Blood Transfusion or Blood on the Streets
China’s Banking System: The 2026 Update Nobody Asked For
“Only when the tide goes out do you discover who’s been swimming naked.” — Warren Buffett
“The time to buy is when there’s blood in the streets.” — Baron Rothschild
In a weird way these two quotes are different lenses on the same idea. An idea essential to our stoic macro investment philosophy. The notion that markets are truth-seeking mechanisms, and sometimes that process requires pain in order to function.
There’s a parallel at the level of an economy. If you conceptualize the economy “like a machine” and then put those machines in a context of “competition,” either directly or indirectly, you realize that there’s some evolutionary thing going on when we talk about how nations “compete.” Even though in reality there is no single unitary thing that is the “American economy” or “Chinese economy” or “European economy” but rather a bunch of individuals and organizations running individual optimization processes, pursuing their version of the good or the profitable. Such that when we say things like “The Chinese are destroying the European automobile industry” we don’t mean that literally. Even when conceptualized at senior levels by policymakers, you can’t just dictate that folks stop buying BMWs and start buying BYDs. You need people to make the cars, people to transport them across oceans, people to sell them, and critically, people to BUY them.
This last part, at least in my opinion, is part of the super power of markets. The notion that for the most part you have this great engine which does a pretty great job of aggregating information through consolidating billions and trillions of these little decisions into something which can be (usually inaccurately) summarized as “Taiwan GDP grew by 8.7% last year.” Forgetting, for the moment, the vagaries of nominal vs real GDP, or CPI vs PPI vs PPP vs GDP deflators and all the technocratic caveats baked into that statement.
So yes, we can think about these machines in aggregate as being in competition when they are representative of markets which are competitive, and in doing so, providing value by bringing the best products to markets at the lowest cost for the greatest number of people.
So where does pain come in?
Well, there’s the pain of losing. The pain of shutting down. The pain of changing ways of operating. Add in a financial system to this engine, and you get the pain of losing money, or going under, the second-order consequences of the fact that my liabilities are your assets, and if I don’t come up with the goods (or mortgage payment), then your asset isn’t worth as much. Add in the notion of leverage, and maybe the fact that your claim on me isn’t worth as much as you thought means your assets are now lower in aggregate than the value of your liabilities, and we start to have a problem which has the possibility to cascade.
A lesson borne out by everything from Lehman, to FTX, to the bank “panics” that used to hit the American economy like clockwork every 5-8 years before the emergence of the Fed as lender of last resort and bailout-in-chief.
You can imagine a world where all this pain goes away, but that’s also a world with pretty terrible incentives, and probably a much worse machine. How many football teams would go through the pain of preseason “double sessions” (aka 12hr practice/workout marathons that last two weeks) if not for the very real pain of losing? How many monopolies lose their way, when buttressed for too long against the fire of competition?
The two quotes that started this ramble kind of represent the “bottoming” part of what some would call a panic, or credit crisis, or deleveraging, or depression. The notion that a) sometimes you don’t really know who’s been running a bad machine until you put the stress of tough times on everyone, and b) sometimes in order to restore confidence (investor or otherwise) you need to actually see the folks who “got over their skis” the most in pain. You need to know the machine worked.
And at the economy level, we kind of get this. Productivity ironically rises in the teeth of a recession, as firms tend to fire (on balance) their least efficient workers, and make do with less. Steam cleaning the pipes and refining their production processes to the bare essentials. This then creates “slack,” at least in the labor markets, and often in the input markets like commodities and energy, which some enterprising young sort decides to pick up and put to better use. Something we all can kind of see coming with the potential explosion of automation on the near-term horizon.
Anyway, there’s a point to all this meandering which isn’t just to say that yes the pain is necessary and in some cases good, but also to reexamine one of our favorite topics, the Chinese financial system, and ask a) what’s going on, b) what can we infer about the goals of policymakers from their revealed preferences, c) where this whole machine is going.
Which brings us, finally, back to the title of this ramble: blood transfusion or blood on the streets.
The Short Version (What We Found)
Before we get into the details, here’s the punchline.
The Chinese banking system is sitting on somewhere between $4.4 trillion (base case) and $7.7 trillion (stress) in direct losses. Losses that haven’t been recognized and are being actively concealed through extend-and-pretend lending, shadow banking, and regulatory forbearance. (All USD conversions at ~7.1 RMB/USD unless noted)
The total buffers in the system (equity, provisions, Tier 2 capital, government recapitalization) nominally add up to about $6.9 trillion. Sounds like enough to cover the base case, right? But you can’t deploy all of that without breaching regulatory capital minimums. Once you subtract the ~$4.1 trillion locked up by CAR floors and G-SIB surcharges, the actually usable buffer is closer to $2.8 trillion. In the base case, the system needs to fill a shortfall of roughly $1.1 trillion to get back to regulatory minimums — that's the gap after netting provisions already taken against specific exposures, not a simple subtraction of usable buffers from gross losses. In stress, that gap blows out to $4.4 trillion.
The strategy makes sense on its own terms: the dynamics are reflexive. If they force recognition of the losses, the panic itself makes the stress scenario more likely. Bank stocks crater, margin calls cascade, depositors bolt for the exits, and the $4.4 trillion stress hole becomes the actual hole. But if they can keep things calm — extend, pretend, let the NIM do its work — the math says they can earn their way back to adequate capitalization in roughly 3-4 years on the base case numbers. The system generates ~$330 billion a year in profits. Divide the $1.1 trillion shortfall by that and you get your timeline. Doesn’t mean the banks are healthy, but it would imply the system is solvent, as opposed to now.
So the bet isn’t crazy. It’s the same bet Japan made. The difference is what happens when it doesn’t work.
Because unlike Japan, China has a closed capital account. And that cuts both ways. On one hand, it’s harder for money to flee, which is precisely why gold-in-China has become the trade of the decade, as 1.4 billion people look for anything portable and non-RMB denominated to park their savings. On the other hand, a closed capital account means there’s more pressure building behind the dam. Japan’s savers could diversify globally during the lost decades, releasing steam gradually. In China, when the pressure finds a crack, and it always finds a crack, the force behind it is going to be something else entirely.
The response from policymakers isn’t denial exactly. It’s more deliberate than that. They understand the math. The strategy is to bleed the losses out slowly through NIM compression and regulatory forbearance over the next two decades, rather than recognize them all at once and trigger the systemic event they’re trying to prevent. The problem is that the conditions required for it to work, stable NIM, growing earnings, a solvent funding base, are all deteriorating simultaneously, and the tools to fix them are running out.
What that means in practice: the banking system is generating roughly $1.1 trillion per year in implicit losses through four channels. $550B from collapsed land-sale revenues, $183B from loan write-offs, $300B in LGFV debt service at artificially low rates, and $100B in annual NIM compression. Every year that number compounds. Every year the earn-through timeline gets longer.
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