Experimental feature

Listen to this article

Experimental feature

Financial markets are underplaying the risk of a strike on Iran’s nuclear facilities. That is the warning from Mark Cliffe, chief economist at ING Group.

“Financial markets are assuming that an Israeli and/or US attack on Iran is unlikely. However, bellicose rhetoric from Israel and an imminent build-up of US forces in the Gulf suggest that they could be in for a shock,” he argues.

Mr Cliffe believes that an imminent attack would seem unlikely, given the weakness of the Israeli and US administrations and hopes for regime change in Iran. “However, Iran’s threats to Israel’s existence and fears that it will acquire nuclear weapons within two years suggest that President Bush may sanction action before he leaves office at the end of 2008,” he says.

Mr Cliffe says the financial market impact of an attack would be dramatic, even if Iranian retaliation were restrained. “A surprise attack on Iran would catch out markets pricing in little volatility. Oil and gold prices could spike, boosted related equities, debt and currencies. Other credit spreads would widen”.

Mr Cliffe answers your questions below on what an attack on Iran would mean for investors and how markets should deal with geopolitical risk.

What is your analysis of Iran’s retaliatory capabilities and its consequent effects (and likely duration) on the physical flow of oil and shipping from the Persian Gulf? The question is not only about the closure of Hormuz straits but also about the possibility of disruption to oil and gas terminals at Saudi, Kuwait, Qatar etc.
Borzou Aram, London

Mark Cliffe:

In our report on this scenario, Charles Robertson and I set out a range of possible Iranian responses:

A. Retaliating against Israel only Attacks on Israel could be done in five ways:

1) Ballistic missile attacks - Iran has developed Shahab-3 missiles that are capable of hitting Israel. Air defence systems may offer some protection to Israel, but a re-run of the 1991 Scud attacks by Iraq is likely.

2) Hizbollah/Hamas attacks into Israel.

3) Terrorist attacks on Israeli targets abroad.

4) Retaliation against the 35,000 Jews estimated to be living in Iran.

5) Using chemical weapons. It is unclear whether these - if they exist - can be loaded onto missiles.

B. Retaliating more widely Beyond attacking Israel, Iran has a range of options. Everyone believes, Iran included, that any Israeli action against it would have received at least tacit approval from the US. Therefore, the fear is that Iran may react by:

1) Cutting off oil supplies to the global economy - by closing the Straits of Hormuz, attacking oil installations in GCC countries or even cutting off its own oil supplies - so pushing up oil prices to beyond $100/bbl. In practice, it could achieve such an effect, at least in the short run, by merely threatening such actions.

2) Boosting military supplies to Iraqi Shias to intensify the civil war there, or Afghan forces fighting the US, or even send in hundreds of thousands of troops to Iraq - as China did in North Korea during that war.

3) Supplying terrorist forces in the Gulf region and attempting to provoke revolution among the pro-US governments in the GCC.

4) Encouraging terrorist actions globally against the US and other Western interests. While these options have been examined by military and political analysts, there are major doubts about Iran’s ability and willingness to use them.

On the latter point, the Iranians, like the Israelis, will be concerned about the existential threat ranged against them, and the heavier their retaliation against US and Israeli interests, the heavier the likely counter-strikes by the US and Israel. In the end, this is thought that weighs against the most catastrophic scenarios.

My guess is that emerging markets would suffer most in case of an attack on Iran. Still, I can imagine there could be quite a different reaction on different emerging markets. Russian stocks could benefit from it, for instance. What is your view?
Pavel Curda, Prague

Mark Cliffe: I agree that emerging markets would be most vulnerable. They have headed the surge in risk assets over the past three years, and a surprise attack on Iran would catch out markets pricing in little volatility. The US dollar, government bond yields, stock markets and industrial raw materials would all fall. Oil and gold prices, could spike, boosting related equities, debt and currencies.

Other credit spreads would widen, and the unwinding of carry trades would see funding currencies benefit, although Japan, dependent on Iranian oil, might lag others such as the Swiss franc. The duration of these effects would depend on the extent of Iranian retaliation: a constrained response would make them short-lived.

In what time frame is an attach likely to happen? In times of war the Swiss currency is likely to increase. But that also is true for the Norwegian krone (NOK), due to oil production (ca. 2.8 Mbpd). Which one will increase most, CHF or NOK in the event of a strike on Iran?
Terje Pettersen, Norway

Mark Cliffe: On the timing, it is hard to be definitive. The rhetoric on both sides has been hotting up in the last few months. Israel is anxious that Iran, which is threatening its very existence, may have nuclear weapons capability within the next two years. Moreover, this coincides with the Bush Administration’s remaining tenure, and the possible prospect of a less assertive Democratic US President reinforces many analysts’ belief that action, failing a peaceful evolution of the nuclear dispute with Iran, will happen this year or next. The thought that action may be more imminent, say from late February, is linked to the new US military deployments in the Gulf and the UN sanctions deadline of February 20/21.

On the currency front, the Swiss franc (CHF) is likely to be a greater beneficiary of dollar weakness than the euro, given that it is already at historically low levels. Moreover Switzerland is less dependent on oil than most (2 per cent of its electricity is generated by fossil fuels). The Norwegian krona (NOK) and Japanese yen would also probably benefit, though the latter may be marginally impacted by concerns over Japan’s dependence on Iran’s oil imports.

However, the relative performance of the CHF versus the NOK would be a tougher call: initially the CHF might outperform on safe haven flows, but a durable rise in oil prices, depending on the course of the conflict, might see the NOK subsequently rise more strongly.

My question is how likely is an attack at all? Iran’s installations are well spread and some are deep and well protected leaving little chance of success. How can you justify discussing the outcome rather than how it would happen?
Deepak, London UK

Mark Cliffe: The problem for financial analysts is how to attach a probability to such a scenario. However, the impact of this scenario is potentially so large that, even if you happen to attach a very small probability to it, you have to take it into account. The fact that so many political observers attach a substantial probability to it reinforces this need.

For example, Arab League Secretary General Amr Moussa suggested last week that the odds were “50/50”. Since my colleague Charles Robertson and I wrote our report on this scenario, we have been surprised how few institutional investors have given it much thought, still less taken action to hedge their portfolios. This suggests that the financial market reaction could be large if an attack does happen.

As for its chances of success, opinions among military analysts vary. It is worth bearing in mind that success might just be measured in terms of the military impact, but the political as well. Some analysts argue that it could be a trigger for regime change in Teheran, although others argue that the successor regime might not be friendlier to the US! Note too that such uncertainties are key to the turmoil that could be unleashed on the financial markets, which is the principal focus of our work.

If Iran switched its central bank reserves from dollars to the euros, how would markets interpret this? And how would it affect the dollar?
Maria O’Brien, New York, US

Mark Cliffe: This would have a very limited impact on the markets. Iran has only $58.5bn in reserves, and is reported to have shifted more than 70 per cent into non-dollar currencies. A bigger concern is the response of other central banks (see below).

I would like to know what is your downturn volatility forecast for the Istanbul Stock Exchange Index and for Turkish lira futures contracts if an attack on Iran takes place. Secondly how long would it take for the capital markets to recover to pre-strike levels?
Ali Dicleli, Manchester, UK

Mark Cliffe: ING’s strategists have estimated that both Turkish stocks and the lira could fall by 15-20 per cent in an Iran attack scenario. How quickly they bounced back would clearly then depend on the subsequent evolution of the conflict (see below), but an additional complicating factor would be the presidential election in May.

Canada with the second largest reserves of proven oil behind Saudia Arabia should see a permanent ‘lift’ in the value of its currency, relative to the US dollar, and perhaps experience a move over $0.90. What is your view on that hypothesis?
Allister Kyle, Canada

Mark Cliffe: For Canada, and other oil producers, much would depend on the extent and duration of any rise in oil prices. Clearly, the initial panic reaction would see oil prices spike, probably breaching last August’s high, with talk of $100/bbl likely to be rife. Oil linked currencies would undoubtedly benefit, and Canada, with its tar sands, could easily see its currency breach $0.90.

However, the key question is how Iran would respond to the attack. Despite its own substantial output of crude oil, given its own dependence on imports of refined products (including petroleum), it would have to think very carefully before disrupting oil supplies from the Gulf, vulnerable though they may be. Any such action would trigger a further escalation of the conflict, not just with the US, but with its neighbours and possibly other US allies. Many political and military analysts argue that the Iranian response might be confined to direct action against Israel or attempts to ratchet up the violence in Iraq, rather than directly threatening oil supplies.

Even if the conflict were more protracted, it is possible to argue that the initial panic spike in oil prices might go into reverse before year end, as economic activity fell back and/or some prospect of a resolution of the conflict emerged. Although there are many ways in which the story might play out, the US Administration’s supposed ambition for regime change in Teheran is thought by some to reflect a desire to secure more reliable oil supplies and lower oil prices. If that were to come to pass, oil related currencies and asset prices might also fall back.

Would an attack on Iran trigger a wider move away from dollar reserves (if not an outright run of sorts), by foreign central banks? Could that, in turn, cause hedge funds collapses and the need for the US Fed and Treasury to deploy rushed liquidity via their Plunge Protection Team, thereby effectively filling in for the daily $2.5bn of foreign borrowing by the US? Your tying such systemic issues together would prove invaluable.
Daniel Johnson, Orange County, California

Mark Cliffe: In my view, such a shift would not be the most likely outcome. Even if an attack on Iran, whether by Israel or the US, led to international condemnation, this would not necessarily lead to foreign central banks taking action to shift their reserves.

First, some countries would be publicly supportive of the attack, and others privately. Second, even those condemning the attack would have to consider the impact of off-loading of dollar reserves on their value (a large scale flight would exacerbate capital losses on holdings of dollar securities) and on the country’s foreign exchange regime.

On the latter point, many countries are constrained on what they can do with their foreign exchange reserves by the fact that they are running either a fixed exchange rate versus the dollar or a heavily ‘managed float’.

Therefore, they can only off-load their reserves to the extent that they are prepared to change their policy and see their currencies rise versus the dollar. Many would not be prepared to do that.

However, this is does not mean that the US dollar would emerge from any attack on Iran unscathed. As we have seen after other geo-political upsets, the general sentiment in the foreign exchange market would likely turn against the dollar, likely driving it down against other major floating currencies.

Moreover, turmoil in other financial markets, particularly if the timing and extent of the action was surprising, would likely, as you suggest, send the financial authorities into crisis mode. The major central banks would no doubt stand ready to flood the markets with liquidity and cut interest rates sharply as required. The duration of such responses would then depend on the course of any subsequent conflict.


At ING, Mr Cliffe oversees a global research team in 16 offices around the world. Prior to joining ING, he was chief international economist at HSBC. In a 25-year career in markets, he also has worked at Nomura Research and ANZ Merchant Bank.

Copyright The Financial Times Limited 2018. All rights reserved.

Comments have not been enabled for this article.