(Bloomberg) -- Germany’s close trade relations with China could wreak havoc on the financial system of Europe’s largest economy if they were to deteriorate, the Bundesbank warned.

While direct exposure is relatively small, “significant risks” result from lenders’ relationships with firms at home that are either invested in China or sell a lot of their output there, the central bank said.

Banks also lent large amounts to sectors of the economy that rely on Chinese suppliers for inputs, according to an article in its monthly report.

“A far-reaching disruption of German-Chinese economic relations would have a significant impact and ultimately increase the probability of loan defaults,” the Bundesbank said. In such a scenario, the financial system may also be affected by high uncertainty on global markets, it said.

While Germany has strongly benefited from China’s rise to become the world’s No. 2 economy, trade ties have grown more tense in recent years. In 2023, the European Union opened a probe into Chinese subsidies for electric vehicles, to ward off cheap imports. Beijing responded with an investigation into European liquor products.

Russia’s war in Ukraine and conflict in the Middle East have also highlighted geopolitical risks. Germany has struggled to gain momentum since the Kremlin shut off natural gas supplies, sending energy prices higher and pushing the government to quickly find alternative sources.

The damage to Germany would be particularly grave if political tensions were to lead to a sudden “decoupling” from China, the Bundesbank said. A purely economic crisis in the Asian nation was deemed more manageable.

At end-2022, German banks’ exposures to firms strongly invested in China was almost €220 billion - about 7% of their risk-weighted assets, according to the Bundesbank. Large, systemically relevant lenders were more heavily involved than smaller rivals.

“Companies and politicians should continue their efforts to reduce risks and strengthen the resilience of the German economy,” it said. “For financial institutions, it seems relevant to keep an eye on indirect vulnerabilities that can arise through the business activities of borrowers.”

A separate report published Wednesday by the German Chamber of Commerce in China showed most German companies in China think the Asian nation’s economy is declining and will take at least a year to rebound.

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