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A sign is pictured outside the Bank of Canada building in Ottawa September 7, 2011.

© Chris Wattie / Reuters/REUTERS

The Bank of Canada is warning that an "abrupt correction" of Toronto's overheated condo market could quickly spread to the rest of the housing market, threatening the broader economy.

The central bank reiterated its concern Thursday about a glut of unsold condominiums, particularly in Toronto, in a twice-yearly review of the health of the financial system.

"If the upcoming supply of units is not absorbed by demand as they are completed over the next 12 to 30 months, the supply-demand discrepancy would become more apparent, increasing the risk of an abrupt correction in prices and residential construction activity," the bank said.

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The fallout would hit jobs, incomes, and consumption and eventually undermine bank loan portfolios, according to the report.

The central bank suggested that developers may be putting up condo units at a faster clip than justified by population growth.

The question of whether the housing market is headed for a crash has been stoked by recent warnings from the Organization for Economic Co-operation and Development that Canada is now among the top three most overvalued real-estate markets in the world, relative to rents and incomes.

The Bank of Montreal weighed in on the debate Thursday, accusing people of "bubble mongering" and exaggerating overvaluation fears. In a report, senior economist Robert Kavcic acknowledged that prices aren't cheap in Toronto and elsewhere, but he said the real-estate market is still "miles away from the severe bubble conditions of the late 1980s."

Despite its warning about real estate, the Bank of Canada concluded the risks facing the financial system "have decreased somewhat" in the past six months, according to the review – the first issued from the bank under the watch of new governor Stephen Poloz.

The bank cited an easing of short-term risks in the United States and Europe, the modest global economic recovery – and a "constructive evolution of imbalances" in Canada's housing sector as the growth of household lending has tempered. The bank noted, for example, that household debt accumulation has continued to slow and is now "broadly in line" with growth in disposable income. It also said housing starts and prices have stopped rising in many markets.

The report warned that housing prices in this country could be subject to "a sharper correction" than the so-called soft landing now under way, stemming from the globe's chronic economic problem child: Europe.

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The bank drew a line from Europe to Canada by warning that if the euro zone can't find a way to proceed with badly needed fiscal and structural reforms – an area where "little progress has been made" – it could mean a prolonged return to financial health for the area's countries and banks.

That in turn could "undermine the political will" to proceed with needed reforms and expose the region to "an adverse shock [that] could have a significant impact on the Canadian financial system through financial, confidence and trade channels" and spread to the balance sheets of Canadian banks and the domestic economy overall.

"The most important risk to financial stability in Canada continues to stem from the euro area," according to the report.

Over all, the Canadian financial system "remains robust" as Canadian banks maintain healthy balance sheets and have an abundant access to low-cost funding and corporate leverage "remains near all-time lows," the Bank of Canada said. But given the risks from abroad as well as the domestic housing situation, the overall level of risk is "high" by the bank's assessment.

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