Australian banks' credit ratings would be cut by up to two notches and house prices would fall by as much as a quarter if China's economy were to slow sharply, Standard & Poor's says.
In a new report assessing how Australia's financial system would respond to a "hard landing" in China, the credit rating agency said a dramatic slowing in Asia's growth engine would have severe ripple effects for the domestic economy.
S&P said a hard landing in China - where growth would slow from about 7.5 per cent now to 5 per cent - would be unlikely, and attached only a small probability to such a scenario.
If growth did slow this sharply, however, it said Australian banks would face credit rating cuts because of their heavy exposure to the domestic economy and the $1.2 trillion mortgage market.
A hard landing in China would severely dent Australia's growth, it said, causing house prices to fall by as much as 25 per cent. The unemployment rate could surge to 10 per cent, from 5.7 per cent today.
Banks are heavily reliant on economic conditions and would feel such a change through rising bad loans.
The report said the biggest banks that were "highly systemically important" - likely to be the Commonwealth Bank, Westpac, ANZ and NAB - would probably benefit from government help under the most pessimistic conditions.
This would limit their downgrade to one notch, from their present level of A+ to AA-.
Small and mid-sized banks, however, would be less likely to benefit from government support, the analysts said, and would face downgrades of one or two notches.
"An economic hard landing in China would be hard felt by Australian financial institutions," the report said.
"This is because a severe slowdown in China would result in a dampening effect on capital investment, a significant negative impact on Australian exports, and weakening business and consumer sentiment and economic prospects in general."
National Australia Bank chief executive Cameron Clyne said the main threat to house prices would come from higher unemployment, but it would have to get to levels of more than 10 per cent to cause a dramatic reaction.
"The biggest thing that will cause a housing price collapse will be unemployment, because ultimately if people don't have jobs they can't go out and buy houses," Mr Clyne said.
The government is forecasting that unemployment will rise from 5.7 per cent now to 6.25 per cent this financial year, but Mr Clyne said this would not cause a housing collapse.
Despite the risks, S&P said it thought the most likely outcome would be a "soft landing" - Chinese growth of 7.3 per cent this year and next against 7.5 per cent now.