Follow Canada? Only at your own risk.

April 27, 2011: 10:36 AM ET

Canada has been held up as a picture-perfect economic example, but once rates start to rise, things could get ugly fast for our northern neighbors.

FORTUNE – Oh Canada. During the past few years, our neighbor to the north has been the envy of the world for the strength of its economy. The country's recession was shorter and milder than in other industrialized countries, thanks largely to tighter financial regulations and stricter lending than in the U.S. and Europe, where banks took huge hits from taking on too many risky home loans.

Toronto economy

Downtown Toronto

Last year, President Obama said the U.S. should look to Canada's banking system as a model to follow. Canada's flow of credit was not dramatically disrupted as it was elsewhere and the country's large savings helped it finance stimulus when its economy contracted. Canada's home prices did fall by about 11% during the recession, but that was nowhere close to the scale of the U.S. housing market's collapse. And even as many economists expect U.S. home prices to continue falling even further, prices in Canada today are about 9% higher than they were a year ago.

But even an economy that's performed spectacularly has its problems, and it's only reasonable to wonder if Canada really is the model everyone should mimic. Capital Economics David Madani is one of the few who has raised the question. The country's recent growth has largely been driven by super-low interest rates. With relatively cheap borrowing costs, prices have surged for housing -- nearly doubling in the past ten years nationally -- and for commodities, which make up nearly half of Canadian exports.

Madani believes housing prices in Canada have a long way to fall, putting the economy  in a very tough spot. His forecast calls for home prices to decline by 25% "over the next few years," suggesting a housing crash similar to the U.S. and other countries. Housing might seem affordable now, but factor in expectations of inflation, and affordability becomes further from reach.

And then there's the likelihood of higher interest rates, which would send the cost of home purchases even higher. In January, Canadian Finance Minister Jim Flaherty announced steps to tighten record household borrowing amid worries of Canada's rising debt. For the first time in 12 years, the ratio of household debt to disposable income in Canada, at 1.48, exceeded the United States at 1.47.

"Even small rises in official interest rates have been shown to have a big effect on homeowner confidence in other countries under similar circumstances, as they can change perceptions toward the housing market very quickly," according to Madani's report. "As such, if the Bank of Canada does resume its monetary tightening this year, this could easily prove to be a tipping point for a house price collapse."

Although the central bank has kept its benchmark rate at 1% since September, Canada's primary securities dealers expect the next interest rate hike to come as soon as May or July amid worries of rapidly rising commodity prices, according to a March Reuters poll.

Madani suggests that commodity prices could be another wild card. Since natural resources account for about 10% of Canada's economy and about 45% of exports, Canada has experienced robust growth as prices for goods such as crude oil and metals have surged. But there's reason to believe that's a lesser worry this time around, because unlike past booms, the current one is being driven partly by strong demand from rapidly developing emerging markets including China and India. Bank of Canada Governor Mark Carney has said the boom could last for decades, but it's still hard to ignore how vulnerable Canada is to the direction of commodity prices.

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Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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