OREANDA-NEWS. August 13, 2015. In this interview, Peter Westaway, Vanguard's chief economist in Europe, discusses developments in the ongoing debt crisis in Greece, including the country's prospects in the euro zone.

Vanguard: Why have markets been obsessing about the fate of Greece, a small country in Europe?

Peter Westaway: Although Greece's GDP (gross domestic product) is less than 2% of the euro zone's, the nation's crisis has raised questions about the integrity of the currency union in Europe. Does the euro zone represent a union of countries irrevocably committed to using the euro as their currency, or is it merely a fixed exchange rate regime where countries may leave during a crisis? If Greece were to abandon the euro now, it could severely undermine the credibility of the single currency. And it could contribute to near-term instability in financial markets. Certainly, it is unlikely that "Grexit" [the term coined for Greece's leaving the euro] would have caused a financial market meltdown now as it probably would have in 2011, when the crisis first broke. For a start, the European Central Bank (ECB) now stands ready to do "whatever it takes" [to quote ECB President Mario Draghi in a 2012 speech] to save the euro. And many of the other peripheral countries that had been at risk for leaving the euro have since undertaken tough fiscal measures and structural reforms. Even so, there was still a risk that Grexit could have been Europe's "Lehman moment," with unforeseen adverse consequences.

So is Greece's fate as a member of the euro zone now secure?

Mr. Westaway: Greece's place in the euro zone now looks more secure than it did, following a recent 11th hour agreement between the Greek government and its European creditors. Those creditors are now providing bridge funding for Greece to pay off its immediate liabilities, not least to the ECB and the Bank of Greece, and the arrears to the International Monetary Fund (IMF). This was achieved through the Greek parliament's approval to begin implementing further tax and spending measures that the Greeks had only recently rejected in a referendum. The measures also included an acceleration of the structural reform program to make the Greek economy operate more efficiently and the use of some privatization revenues as collateral.

Isn't it unrealistic to expect Greece to undertake reforms, as it has not fulfilled the conditions underpinning its previous financing deals?

Mr. Westaway: It's true that Greece has not delivered on all the conditions of its earlier funding programs. This is partly because the fiscal austerity imposed on Greece hurt growth more than the creditors had foreseen. And in any case, it is unfair to the Greeks to say they have done nothing. Greece started with a huge primary structural fiscal deficit [that is, excluding debt interest payments and adjusting for the business cycle] of greater than 10% of GDP. The fiscal balance had moved back into surplus last year. This was an adjustment of unprecedented severity. On structural measures, too, Greece has, according to the Organization for Economic Cooperation and Development, made more reforms than any other country in Europe since 2011—though admittedly from the worst starting point.

Is Greece's debt sustainable?

Mr. Westaway: This is a crucial question, and probably the most controversial one. In 2013, Greece's private-sector debt was partly restructured. Most of the remaining private-sector debt was taken up by European governments and policy institutions such as the IMF, ECB, and European Financial Stability Facility—much of it at reduced interest rates. As a result, Greece's debt-to-GDP ratio is still very high at 170% of GDP, with a debt interest burden of around 4% of GDP [as of 2013]. That is high, but by no means the highest in the euro zone. Even so, if Greece is to reduce its debt, European creditors have deemed that Greece will need to run primary surpluses of 3.5% of GDP for the foreseeable future. But most commentators believe that some form of debt restructuring will be needed if Greece is to survive and prosper within the euro zone. The IMF shares this view—its sustainability analysis suggests that the official-sector creditors will have to forgive some of the debt. Germany and the European creditors have not ruled this out, but they have made clear that this will not happen until Greece has made more tangible progress on economic reforms. And there is still resistance from Germany to outright reduction in the debt principal, something the IMF believes is necessary. How this circle will be squared will become clear in the negotiations in the weeks and months ahead.

Wouldn't Greece be better off if it abandoned the euro?

Mr. Westaway: It has often been suggested that Greece would be better off if it left the euro, introduced a newly competitive devalued currency, and loosened the fiscal austerity by defaulting on all its debt, thus allowing an immediately looser fiscal stance. The resulting boost to demand would transform Greece's growth prospects, it is argued. In our view, the reality may be rather different. With a newly independent currency, the Bank of Greece would find it difficult to prevent the large currency devaluation from being negated through high inflation. And if Greece did default on its debts, it might not regain access to private capital markets for many years, so it would have to run a balanced budget in the meantime. Perhaps most significant, all the structural reforms that European creditors are requiring Greece to carry out within the euro zone could be delayed indefinitely outside the single currency. So in our view, even though the short-term prospect is fairly arduous in either case, Greece may be better off inside the euro.

Are there risks that other countries will flirt with leaving the euro?

Mr. Westaway: We think the risk that other countries will leave the euro zone is much smaller now that Greece appears to be staying in. Countries such as Ireland, Spain, and Portugal have undertaken much of the fiscal restraint and many of the structural reforms that their own bailout packages mandated. And the ECB stands ready to prevent financial market contagion by deploying its balance sheet in the form of quantitative easing measures, or even by launching the as-yet-unused Outright Monetary Transactions program.

How does uncertainty about Greece affect growth in the wider euro zone?

Mr. Westaway: Even though Greece is small, uncertainty surrounding it has dampened European growth. The boost to European growth and economic sentiment that had followed the ECB's decisive quantitative easing policies appeared to lose steam as the Greek crisis flared up again in recent months. This is understandable. Many firms, inside and outside Europe, have been reluctant to invest in Europe while the shape of the monetary union is still in doubt. We expect that the improved financial market sentiment after the partial resolution of the Greek crisis will show up in stronger economic numbers.

Should investors shun European assets while this uncertainty lingers?

Mr. Westaway: It is tempting to avoid European investments until the situation is resolved, but doing that risks missing out on a possible rebound in European assets. And of course, economic and market uncertainty is not confined to Europe. Long-term investors should try to avoid fine-tuning their portfolios in response to transitory headlines.

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