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 report assessing how Australia's financial system would respond to a "hard landing" in China, the credit rating agency says a dramatic slowing in Asia's growth engine would have severe ripple effects on the domestic economy.
S&P sees a hard landing in China - where growth slows from about 7.5 per cent now to 5 per cent - as unlikely, attaching only slight probability to this scenario.
But if growth did slow this sharply, it says Australian banks would face credit rating cutsbecause of their heavy exposure to the domestic economy and the $1.2 trillion mortgage market.
A hard landing in China would severely crimp Australia's growth, it says, 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 rely heavily on economic conditions and would feel such a change through rising bad loans.
The biggest Australian banks that were "highly systemically important" - likely to be Commonwealth Bank, Westpac, ANZ and NAB - would probably benefit from government help under the most pessimistic scenario.
This would limit the downgrade for the big banks to one notch, from their present level of A+ to AA-.
Small and mid-size banks would be less likely to benefit from government support 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 says.
"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."
The prediction came as NAB chief executive Cameron Clyne said the key threat to Australian 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 in the property market.
"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 unemployment to rise from 5.7 per cent today 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 likely outcome would be a "soft landing": Chinese growth of 7.3 per cent in 2013 and 2014 compared with 7.5 per cent now.