Expert View: Be very afraid if Bush takes the war on terror to Iran

Iran is a much bigger oil producer than Iraq. The surge in prices might be greater this time

The risk of a US attack on Iran can no longer be dismissed. George Bush has identified the country as the next potential target in his campaign against terrorism and tyranny. A military attack is still unlikely, but the consequences are too serious to ignore. The market impact could surpass that of the Iraq war in 2003.

The risk of a US attack on Iran can no longer be dismissed. George Bush has identified the country as the next potential target in his campaign against terrorism and tyranny. A military attack is still unlikely, but the consequences are too serious to ignore. The market impact could surpass that of the Iraq war in 2003.

The US is impatient for progress. Aside from concerns about Iran's nuclear programme, its sponsorship of terrorism and the insurgency in Iraq - on top of its threat to Israel - suggest that the US may seek a regime change within the next two years. On the other hand, elections in the UK, the US's leading ally, and in Iran itself, argue for action being delayed beyond May.

Since the US has put the nuclear weapons issue at the heart of its dispute with Iran, the presumption is that any military action would initially involve a targeted attack on its nuclear facilities. But whether this would meet the US goal of preventing Iran from acquiring nuclear weapons, still less its ultimate aim of regime change, is doubtful. Thus even if the threatened retaliation by Iran proved to be muted, this would still leave the option of a full-scale invasion "on the table".

Indeed, US military planners may have to allow for the possibility that an attack on Iran's nuclear facilities would be the prelude to an all-out invasion. If so, as in the case of Iraq, a winter assault early in 2006 would be the first practicable opportunity from a military point of view.

If the financial markets' responses in the build-up to the Iraq war were replicated, this would imply: a $12 per barrel increase in the oil price, taking West Texas crude up to more than $60 per barrel; a 14 per cent drop in the Dow Jones, taking other stock markets with it; a plunge in bond yields, taking US 10-year yields down by around 0.75 per cent; and a 10 per cent drop in the US dollar.

But the surge in oil prices and flight from risk might be greater than during the Iraq conflict. Iran is a much bigger oil producer than Iraq, the US is starting from a stretched military and budgetary position, and an invasion would increase the risk of a more serious breach in relations not just with countries in the Middle East but with other erstwhile allies.

The damage to international relations might have a more direct impact on the markets by reducing the willingness of investors to hold US assets. This would compound the downward pressure on the dollar, while offsetting the "safe haven" buying of US Treasury bonds. That said, for most central banks, the priority would probably be to avert a calamitous surge in their currencies. In particular, in its efforts to curb the euro's strength, the European Central Bank might find itself mopping up dollars offloaded by others.

Even if the military victory were swift, the experience of Iraq would make the markets sceptical of the US ability to "win the peace". The terrorist insurgency could be on an even larger scale than in Iraq, and the damage to international relations might prompt a protracted loss of confidence in the financial markets.

Thus the victory rally, the upward leg of the V-shaped pattern the markets traced out for the Iraq war, might be rather more tentative in the case of Iran. The damage this would cause to global confidence, among businesses and consumers, would trigger a severe economic slowdown.

Such thoughts might be seen as a serious deterrent to any US plans to launch an attack on Iran in the first place. But it must be remembered that the Bush administration is not viewing its agenda through an economic prism. As one official, asked about the mounting costs of the war in Iraq, put it: they pale "compared with the costs that the terrorists would like to inflict on us".

Mark Cliffe is chief economist at ING Financial Markets.