A crash of China's shadow banking system would send shock waves through the Canadian economy, depressing commodity prices and triggering a housing market correction, the Bank of Canada warns in a new report.
The central bank said Thursday that the risk of a banking crisis in China has shot up since its last checkup on the health of the Canadian financial system in December.
Other major risks to the Canadian system remain largely unchanged, the bank said, including the threat of a house price collapse at home, sharply higher interest rates or the euro crisis. Indeed, despite the simmering crisis in Ukraine, the central bank judges that the risk of financial problems in Europe have ebbed.
"Our level of comfort, or perhaps I should say discomfort, as policy makers, remains similar to what it was six months ago," Bank of Canada Governor Stephen Poloz told reporters in Ottawa.
So how would China's problems spread to Canada? In a word: commodities. A banking crisis would stall the massive Chinese economy – now growing at more than 7 per cent a year – and sap its demand for much of what Canada produces.
"The resulting decline in global commodity demand and prices would be transmitted back to Canada through its extensive exposures to the commodity sector," according to the report. "The shock to global aggregate demand could trigger a housing market correction in Canada and related stress in the domestic financial system."
The main problem in China is the precarious nature of the so-called "shadow" banking system, made up of thousands of loosely regulated and highly leveraged trust companies. Some of these lenders are already in financial trouble, and a wider banking crash would quickly spread to the rest of the financial system, the central bank said.
Canadian banks have relatively little direct exposure to China, the central bank pointed out. But they are exposed through their ties to British banks, which are much more active in China.
On the home front, Mr. Poloz said high house prices and record household debt remain the most important "vulnerabilities" in the Canadian financial system – a problem highlighted in reports this week by both the International Monetary Fund and the Organization for Economic Co-operation and Development.
The OECD, for example, said that 40 per cent of Canadians now live in cities where home prices are "seriously or severely unaffordable," such as Vancouver and Toronto.
The central bank acknowledged in its own report that "valuations are stretched, there is overbuilding in some parts of the country and indebtedness remains high."
But Mr. Poloz insisted the probability of a housing crash remains low and that conditions are in place for a "soft landing."
Speaking to reporters, he pointed out that housing starts are running below the demands of the growing population and borrowers are being more prudent, slowing the growth of household credit.
He also pointed out that Canadians are now buying less expensive houses than they can afford and taking on smaller mortgages than banks are ready to offer.
"You've seen a fundamental shift in peoples' behaviour," Mr. Poloz said.
Mr. Poloz likened the problems in Canada's housing market to a "crack in a tree." It's not a problem unless a shock comes along to knock it down, such as a sharp rise in interest rates, a recession or a Chinese banking crisis.
The central bank highlighted the growing number of newly built but unoccupied condo units, particularly in the city of Toronto.
"A correction in this important market could spill over into other parts of the housing market through various channels, including buyers' price expectations," the report said.
And for the first time, the bank pointed out the potential risks among smaller financial entities, including credit unions, trust companies and investment funds.
The report said these smaller entities account for as much as 20 per cent of overall lending in Canada.