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While many are watching its stock market, China's real problem may lie with its banking system, according to one hedge fund manager.
Kyle Bass, Hayman Capital Management founder and managing partner, told CNBC's "Squawk on the Street" on Tuesday that Chinese banks will likely experience losses that may affect the country as a whole.
"Those that are watching whether Chinese stocks go up or down aren't paying attention, in my opinion, to what the real problem is," Bass said. "And the real problem is the loans in this banking sector."
The hedge fund manager said that Chinese bank assets rose about 400 percent since 2007, and are now about $31 trillion against an economy with a gross domestic product of $10 trillion.
"When you run a bank expansion that aggressively, that quickly, you're going to have some losses," he said, adding that "the scary thing about that" is a "likely" 10 percent asset loss in that banking sector would amount to $3 trillion.
Such losses would force China to use much of its foreign exchange reserves (which stand at about $3.6 trillion) and sell bonds to recapitalize the banking system, he said.
Bass said these issues are mirrored in many emerging markets—especially those in Asia—and could therefore ultimately affect global GDP.
While the ripples of an emerging market downturn could draw U.S. GDP lower than estimated, countries like South Africa could be seriously impacted.
Bass said his investment group is closing watching nations that run twin deficits, and those that may have to devalue their currency "in order to come back to some level of competitiveness with the rest of the world."
As the loan cycle forces emerging market banks to see steep losses, "the next two years are going to be tough," he said.
"We talk about this race to the bottom and this currency war. Well it's happening as we speak," he said. "China literally just started with its devaluation process—wait until you see where that goes."