Australia's heavy reliance on debt to buy illiquid property assets makes it the most vulnerable developed nation to a sharp economic slowdown, the credit rating agency Moody's has warned.

Key points: Australian households stand out for lower financial buffers and higher leverage

In a study of high income countries and their ability to deal with housing market corrections, Moody's found Australia rated as one of the four most vulnerable to a downturn, along with New Zealand, Sweden and Canada.

However, it found in terms of liquid assets relative to debt, Australia was the most exposed should things sour, and not dissimilar to the situation in Ireland just before its property market crashed in 2007.

"Household leverage relative to households' liquid financial assets excluding retirement [superannuation] reserves is particularly high in Australia, at a level comparable to that observed in Ireland on the eve of its housing market crisis," Moody's said.

"This suggests that, in the event of a negative income shock, the scope for Australian households to draw down parts of their financial assets to maintain debt service and overall spending is more limited than elsewhere."

The study found the four key nations all had specific vulnerabilities, with New Zealand most exposed to a reliance on residential construction and Canada heavily reliant on residential investment.

All four had banks with high exposures to residential mortgages, accounting for between 40 and 50 per cent of banking system assets.

"Australian households stand out for lower financial buffers and higher leverage," Moody's said.

Moody's also noted that low wage growth had contributed to a deterioration in housing affordability and delivered higher house prices to income and debt to income ratios in all four countries.

A sharp economic shock would in turn further weigh on incomes and housing affordability, Moody's argued.

"Moreover, to the extent that house price expectations are based on past developments, the more rapid the price increases in recent years, the higher the risk of an abrupt adjustment in price expectations that would amplify the drop in demand for housing."

Sound banking practices limit credit risks

However, Moody's noted Australia's relatively strong banking system and regulatory oversight limited overall sovereign risk and the prospect of a credit downgrade due to a housing slump.

Last month, the banking regulator APRA told banks to further tighten lending practices — particularly to investors — in a bid to cool the property market and a worrying build-up in household debt.

"With high capitalisation levels, conservative business models, and strong liquidity, all four banking systems rank among the top 10 in terms of average banks' intrinsic financial strength," Moody's said.

"Although not immune to them, the banking systems would be relatively resilient to negative shocks that involve a housing correction, thereby limiting the potential fiscal costs of sovereign support to banks."