BUDAPEST (Reuters) - The world financial system is broken but the time is not yet right for permanent reform as near-equilibrium conditions have to be reached first, billionaire investor George Soros said on Tuesday.

Billionaire investor George Soros arrives at an event sponsored by the Central European University to deliver the first of five lectures on the global economy and financial markets in Budapest October 26, 2009. REUTERS/Karoly Arvai

Future reforms might need to include restricting or banning some derivatives like credit default swaps (CDSs) and knockout options which could create hidden imbalances, Soros said in a lecture in Budapest.

Soros said the economy has to be first stabilized through increasing state debt and expanding the monetary base and only afterwards should the monetary base be reduced and the regulatory framework revamped.

“We are still in the first phase of this delicate maneuver,” Soros said. “This is not the right time to enact permanent reforms.”

“The financial system and the economy are very far from equilibrium and they cannot be brought back to near-equilibrium conditions by a straightforward corrective move,” Soros said.

Soros added that once the financial system reached a state of near-equilibrium, regulatory authorities must take an active role in preventing asset bubbles, even at the cost of erring at times.

“Since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big,” Soros said. “Authorities have to accept the assignment, knowing full well that they will not be able to meet it without mistakes.”

Soros said a key task will be controlling the availability of credit through variable margin and capital requirements while certain financial instruments also need to be reformed.

“Certain derivatives, like CDSs (credit default swaps) and knockout options, are particularly prone to create hidden imbalances, therefore they must be regulated and, if appropriate, restricted or forbidden,” Soros said.

Soros said the new regulatory framework would reduce the profitability of the bank sector but this has to wait until the sector is fully back on its feet.

“To reduce their profitability now would be directly counter-productive,” Soros said. “Regulatory reform has to await the second phase, when the money supply needs to be brought under control, and it needs to be carefully phased in so as not to disrupt recovery.”

Soros said there were imbalances in the global financial system now due to quantitative easing and the availability of free financing.

He also said that once the economy stabilizes, authorities should shrink the monetary base as fast as credit revives, as otherwise deflation will be replaced by inflation.