## cr17278

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### Executive summary
- Context and recent outcomes:
  - Headline fiscal deficit fell to 2 percent of GDP in 2016.
  - Household savings rate fell below 4 percent in the first quarter.
  - Unemployment rate fell to 8.8 percent in the second quarter of 2017 from 10.8 percent a year ago.
  - Twelve-month core inflation at 1 percent in July.
  - Staff projects real GDP growth to accelerate to around 2.5 percent in 2017, easing to 2 percent in 2018.
- Banking system and confidence:
  - Caixa Geral de Depósitos (CGD) recapitalized; ongoing sale of Novo Banco; Banco Comercial Português (BCP) received a large capital injection; Banco Português de Investimento (BPI) taken over by CaixaBank.
- Staff view on recovery phases:
  - Phase 1: Sharp decline in unit labor costs (ULCs) as employment fell more than output during the downturn.
  - Phase 2: Competitiveness gains translated into a strong recovery in employment and output, exerting downward pressure on ULCs.
  - Phase 3: ULCs now rising; ULCs rose by 1.7 percent on average in the twelve months through March (y/y).
- Main policy message:
  - Durable structural fiscal consolidation and ambitious bank balance-sheet cleanup are essential to support medium-term resilience and raise potential growth.

### Macroeconomic developments and investment
- Growth drivers and dynamics:
  - Export and investment pickup since mid-2016, alongside continued growth in private consumption.
  - Tourism remains a key growth driver; construction pickup driven by tourism-related renovation and nonresident residential purchases (Lisbon and Porto).
  - House prices increased by 15 percent in cumulative terms over the past two years through end-March, now exceeding the previous peak prior to 2010.
  - Investment in machinery and equipment has picked up, financed primarily through retained earnings.
- Credit and lending patterns:
  - Total credit granted by resident financial institutions to the private sector fell 4 percent in the twelve months through June.
  - Corporate credit fell 7 percent in June (y/y).
  - New lending pickup concentrated in mortgages and consumer loans.
- Investment composition and constraint:
  - Recent recovery in investment supported by tourism-related construction and capital replenishment associated with depreciation.
  - Corporates have financed much of the recent investment via retained earnings; sustained further investment growth likely requires increased bank lending.

### External sector and tourism
- Current account and exports:
  - Current account on track to record a surplus in 2017 as exports pick up and tourism grows, partly offset by higher imports.
  - Non-fuel goods’ exports rose 10 percent during January-June (y/y) compared with 2.5 percent during 2016.
  - Tourism sector: average annual growth in tourism revenues of 11.1 percent during 2014-2016.
- External positions and REER:
  - Net international investment position improved from 118 percent of GDP at end-2014 to 105 percent of GDP at end-2016.
  - Staff assessment: current account shortfall of about 2-4 percent of GDP relative to the surplus needed to meaningfully reduce the NIIP stock.
  - EBA model-based estimates: current account gap of less than 1 percent, a deterioration of about ½ percentage point of GDP.
  - REER assessment: overvaluation of 5-10 percent per EBA results; EBA’s index and level REER regression models indicate an overvaluation of 6½ and 5 percent respectively for 2016.

### Financial markets and monetary support
- Sovereign yields and ECB support:
  - Spreads on 10-year Portuguese bonds vis-à-vis Germany narrowed by 150 basis points from mid-March to around 235 basis points at the end of July.
  - The ECB’s average monthly purchases of Portuguese debt are set to decline by roughly 40-50 percent in 2017.
  - ECB purchases will continue to offset about 90 percent of Portugal’s net bond issuance and more than 40 percent of gross bond issuance in 2017.
- Retail demand and issuance:
  - Demand from retail investors remained strong; authorities expanded issuance of the five-year retail bond introduced in 2016.

### Financial sector developments, NPLs, and policy recommendations
- Recent capital injections and transactions:
  - CGD subordinated debt issue of €0.5 billion at end-March (coupon 10.75 percent); second tranche scheduled in 18 months for €0.43 billion.
  - Agreement to sell a 75 percent stake in Novo Banco to Lone Star in exchange for a €1 billion capital injection (sale conditional on further terms and approvals, including a €0.5 billion voluntary conversion).
  - BCP capital injection of €1.5 billion.
  - BPI taken over by CaixaBank.
- Bank balance-sheet indicators (EBA definition, end-March 2017):
  - NPLs at 16.4 percent of total loans.
  - Corporate NPLs at 29.0 percent.
  - Household loans for house purchase NPLs at 6.7 percent.
  - Consumer and other loans NPLs at 10.0 percent.
  - Coverage ratio increased to 45.5 percent of NPLs as of end-March 2017.
- Capital and profitability:
  - Banking system aggregate CET 1 ratio declined to 11.4 percent (associated with weak profitability).
  - 2016 capital ratio decline was temporary: CGD and BCP capital increases in early 2017 raised the banking system’s aggregate CET 1 ratio by 1.4 percentage points.
- Staff recommendations for banks:
  - Boost internal capital generation: continue cost-cutting, divest non-core assets, downsize networks, diversify income toward fee-generating products.
  - Remove impediments to NPL resolution: facilitate workouts for distressed but viable SMEs; improve judicial and extra-judicial insolvency and recovery processes and collateral enforcement; remove tax disincentives to impairment and write-offs; remove disincentives for public creditors to participate in debt workouts; develop the NPL market.
  - Encourage higher provisioning coverage to incentivize NPL sales to third parties.
  - Create an enhanced creditors’ coordination platform and pursue legislative efforts to facilitate corporate debt restructuring.
  - Explore a private sector-led Asset Management Company as an alternative market-wide solution, considering constraints (limited fiscal space, BRRD and State-aid rules, foreclosure delays, pricing difficulties).
  - Address forthcoming regulatory challenges: prepare for IFRS 9 (expected loss provisioning), anticipate fully loaded Basel III implications and likely need for new equity issuance, and prepare for MREL targets that will likely require tapping wholesale markets.

### Authorities’ views on growth, external adjustment, and banking
- Growth and productivity:
  - Authorities assess structural changes have put Portugal on a higher growth path due to higher skill levels of new entrants and mid-career training initiatives; expect sustained increases in productivity growth.
- Financing and banks:
  - Authorities believe recent developments will improve lending decisions and capital allocation; access to financing not seen as a constraint on investment.
  - View the ECB’s PSPP as now playing a more limited role; expect any tapering to be gradual. Cite a large cash buffer at about 50 percent of financing needs over the next 12 months and ongoing efforts to lengthen maturities.
- On banking sector adjustment:
  - Emphasize long phasing-in of Basel III and IFRS 9 transition period, NPL workout initiatives and banks’ NPL reduction plans, caution against NPL fire sales, vigilance about risks from increased new lending to households, and uncertainty on the cost of MREL.

### Fiscal policy outlook and recommendations
- Recent performance and projections:
  - Headline fiscal deficit target for the year: 1.5 percent of GDP appears within reach.
  - Real GDP growth projection used by staff: 2.5 percent (compared with 1.8 percent assumed in the Stability Program).
  - Public debt: 130.3 percent of GDP at end-2016; staff baseline projects decline to 125.7 percent of GDP at end-2017 and around 126 percent at end-2017 projection referenced elsewhere.
  - Authorities’ Stability Program target: headline deficit of 1 percent of GDP for 2018.
  - Authorities’ planned additional advanced repurchases to the IMF for 2018-2019; Portugal’s credit outstanding to the Fund at SDR 3.9 billion; SDR 1.5 billion threshold for Post-Program Monitoring referenced.
- Staff advice:
  - Structural fiscal consolidation remains essential to keep public debt on a firmly downward trajectory after 2017.
  - For 2018, staff would advise a structural primary adjustment of 0.5 percent of GDP, in line with Portugal’s commitments under the Stability and Growth Pact.
  - Apply any revenue overperformance to a faster reduction in public debt.
- Suggested consolidation focus:
  - Durable spending reform to reduce overlap and improve efficiency of public spending; protect public investment.
  - Contain the public wage bill: stronger wage bill planning, public sector restructuring, streamlining allowances, improving equity among civil servants.
  - Improve efficiency of social spending: priority to improve labor prospects for young adults and rebalance fiscal redistribution toward the youth.
  - Revisit pension reforms to reduce grandfathering: authorities’ planned changes expected to cost less than 0.2 percent of GDP; pension spending at 15.6 percent of GDP in 2014; current reforms backloaded with benefit ratio starting to be reduced only after 2025.

### Growth potential, investment needs, and structural reforms
- Medium-term growth and potential:
  - Without more ambitious structural reforms, medium-term growth expected to converge to staff’s estimated potential growth rate of 1.2 percent.
  - Historical average annual growth was 0.8 percent during 2000-2010.
- Investment scenarios:
  - Staff calculations show that increasing potential growth to 2 percent by 2021 (in line with the authorities’ medium-term framework) would require average annual investment growth of roughly 6½ percent, assuming total factor productivity continues to rise at the current pace.
  - The average annual growth rate of investment in the Stability Program is 4.9 percent, implying that the TFP should grow at about 0.2 percent per year.
  - Staff estimates show the average TFP growth in the past two decades was negative, at -0.26 percent.
  - If the annual TFP growth could accelerate to 0.4 percent, then an around 4 percent growth rate of investment would suffice.
- Policy priorities to raise investment and productivity:
  - Foster human capital accumulation.
  - Increase labor market flexibility.
  - Improve judicial sector efficiency.
  - Reduce corporate debt overhang.
  - Enhance public sector payments discipline.
  - Reduce energy costs.

### Annex I — Public Debt Sustainability Analysis (DSA) and stress tests
- Baseline projections:
  - Staff baseline projects public debt to decline to 125.7 percent of GDP at end-2017.
  - Public debt projected to continue a steady decline through 2022, but remain elevated at 114 percent of GDP in 2022.
  - Headline fiscal deficit projected to stabilize at around 1.5 percent of GDP over the medium term.
  - Fiscal primary balance expected to stabilize at around 2.5 percent of GDP over the medium term.
- Risk assessment highlights:
  - Portugal’s debt ratio exceeds the debt burden benchmark for advanced economies of 85 percent of GDP.
  - Total (public and private) external financing requirements exceed the relevant benchmark under the baseline; this includes non-residents bank deposits, accounting for about 45 percent of GDP.
- Stress test key findings:
  - Growth shock: a shock that lowers output by nearly 4.5 percentage points in 2017–18 (and inflation by a cumulative 1 percentage point) would see debt peak at about 130 percent of GDP in 2019, 11 percentage points higher than baseline.
  - Deflation scenario: a sharper growth shock that lowers output by 5½ percentage points in 2017–18 with deflationary pressures (inflation lower by cumulative 4 percentage points) would push debt to 139 percent of GDP by 2019 and keep it close to that level over the medium term.
  - Interest rate shock: a sustained interest rate shock of 280 basis points throughout the projection period would slow debt decline so that by 2022 the debt-to-GDP ratio is about 3 points higher compared with baseline.
  - Contingent liabilities shock: under a severe scenario staff estimates further contingent liabilities could potentially materialize of about 10 percent of GDP; such a shock would push the 2018 debt ratio to 130 percent of GDP.
  - Combined severe shock: a severe combined shock incorporating macro-fiscal and contingent liabilities adverse scenarios would raise debt to 139 percent of GDP in 2019 and keep it at that level over the medium term.
- Baseline parameter examples:
  - Baseline real GDP growth: 2.5 (2017), 2.0 (2018), 1.7 (2019), 1.5 (2020), 1.2 (2021), 1.2 (2022).
  - Baseline inflation (GDP deflator): 2.2 (2017), 1.7 (2018), 1.6 (2019), 1.8 (2020–2022).
  - Baseline effective interest rate: 3.3 (2017), 3.3 (2018), 3.4 (2019), 3.4 (2020), 3.4 (2021), 3.5 (2022).

### Annex II — Risk Assessment Matrix (selected risks and policy responses)
- Loss of investor confidence due to reform reversals or other negative surprises:
  - Relative Likelihood: Medium; Impact: High.
  - Policy response: strengthen policy buffers; avoid backtracking on reforms; step up growth-supporting policies and banking sector cleanup.
- Financial distress in one or more banks:
  - Relative Likelihood: Medium; Impact: High.
  - Policy response: proactive supervision; balance sheet clean-up; build capital and fiscal buffers.
- Policy and geopolitical uncertainties:
  - Relative Likelihood: High; Impact: High.
  - Policy response: accelerate structural reforms; strengthen fiscal adjustment; clean up corporate and bank balance sheets.
- Stronger US dollar, higher interest rates, and European bank distress:
  - Relative Likelihood: High (for stronger US dollar/higher rates); Medium (for European bank distress); Impact: High.
  - Policy response: step up reforms and bank supervision; shore up banks while preserving public debt dynamics.
- Weaker-than-expected global growth:
  - Relative Likelihood: High (US, euro area, and Japan); Medium (Emerging Markets); Impact: High.
  - Policy response: step up structural reforms; clean up corporate and bank balance sheets.
- Lower energy prices:
  - Relative Likelihood: Low; Impact: Medium.
  - Policy response: reduce exposures to Angola; clean up corporate balance sheets; shore up banks and pursue structural reform.

### Annex III — External stability and vulnerability assessment
- Overall assessment:
  - External position in 2016 was weaker than consistent with medium-term fundamentals and desirable policy settings.
  - In 2017 the current account is projected to deteriorate somewhat with rising import demand, with the surplus in 2016 at 0.8 percent of GDP.
  - Gross external debt remains high at 215½ percent of GDP.
  - Continued exposure to investor confidence shocks remains.
- Current account assessment:
  - EBA model-based cyclically adjusted current account balance: -0.4 percent of GDP vs a norm of 0.4 percent of GDP (negative current account gap of less than 1 percent).
  - Staff assesses a current account shortfall of about 2-4 percent of GDP relative to the surplus needed to meaningfully reduce the NIIP deficit.
- REER and competitiveness:
  - CPI-based REER 5½ percent below pre-crisis peak; ULC-based REER 12 percent below pre-crisis peak.
  - Appreciation around 3½ percent since early 2015 noted; continued appreciation would deteriorate competitiveness.
  - EBA results suggest REER overvaluation in a range of 5 to 10 percent.
- Policy responses to external vulnerabilities:
  - Sustained fiscal consolidation and structural reforms to improve competitiveness and potential growth.
  - Effective work out of longstanding NPLs, accelerated judicial procedures, reduced electricity costs and improved transport links.
  - Labor market reforms to better integrate the low-skilled and long-term unemployed while maintaining past reforms to collective bargaining.

### Key figures and charts referenced (exact numeric highlights)
- Headline fiscal deficit: 2 percent of GDP (2016).
- Real GDP growth projections: around 2.5 percent (2017), 2 percent (2018).
- Household savings rate: below 4 percent (first quarter).
- Unemployment rate: 8.8 percent (second quarter of 2017); 10.8 percent (one year earlier).
- Twelve-month core inflation: 1 percent (July).
- House prices: increased by 15 percent in cumulative terms over the past two years through end-March.
- Total credit to private sector: fell 4 percent (twelve months through June).
- Corporate credit: fell 7 percent in June (y/y).
- Non-fuel goods’ exports: rose 10 percent during January-June (y/y); 2.5 percent during 2016.
- Tourism revenue growth: average annual growth of 11.1 percent during 2014-2016.
- Net international investment position: 118 percent of GDP (end-2014); 105 percent of GDP (end-2016).
- Sovereign spread: around 235 basis points (end-July).
- ECB purchases decline: roughly 40-50 percent (2017).
- ECB offset of issuance: about 90 percent of net bond issuance and more than 40 percent of gross bond issuance (2017).
- Banking sector NPLs and coverage (end-March 2017):
  - Total NPLs: 16.4 percent.
  - Corporate NPLs: 29.0 percent.
  - Household loans for house purchase NPLs: 6.7 percent.
  - Consumer and other loans NPLs: 10.0 percent.
  - Coverage ratio: 45.5 percent.
- Banking capital transactions and sizes:
  - €0.5 billion (CGD subordinated debt); €0.43 billion (second tranche); €1 billion (Novo Banco injection); €1.5 billion (BCP injection).
- Banking CET 1 ratio: declined to 11.4 percent; increased by 1.4 percentage points after early-2017 capital increases.
- Public debt: 130.3 percent of GDP (end-2016); staff baseline 125.7 percent of GDP (end-2017); projected around 114 percent of GDP in 2022 under baseline.
- Pension spending: 15.6 percent of GDP in 2014.
- Recommended structural primary adjustment for 2018: 0.5 percent of GDP.
- Fund-related figures:
  - Portugal’s credit outstanding to the Fund at SDR 3.9 billion.
  - SDR 1.5 billion threshold for Post-Program Monitoring.
- DSA baseline parameter examples (selected):
  - Baseline real GDP growth: 2.5 (2017), 2.0 (2018), 1.7 (2019), 1.5 (2020), 1.2 (2021), 1.2 (2022).
  - Baseline inflation (GDP deflator): 2.2 (2017), 1.7 (2018), 1.6 (2019), 1.8 (2020–2022).
  - Baseline effective interest rate: 3.3 (2017), 3.3 (2018), 3.4 (2019), 3.4 (2020), 3.4 (2021), 3.5 (2022).
- Stress test outcomes:
  - Growth shock peak debt: about 130 percent of GDP in 2019 (11 percentage points higher than baseline).
  - Deflation scenario peak debt: 139 percent of GDP by 2019.
  - Contingent liabilities severe scenario: ~10 percent of GDP shock pushing 2018 debt ratio to 130 percent of GDP.
  - Combined severe shock: debt to 139 percent of GDP in 2019, remaining at that level over the medium term.

*International Monetary Fund staff report (cr17278).*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### CONTEXT: The recovery gains momentum
- Portugal has reduced uncertainty over the near-term outlook through strong efforts to contain spending and meet last year’s headline fiscal deficit, allowing Portugal to exit the Excessive Deficit Procedure.
- Banking system stability and confidence have improved following public recapitalization and capital injections: Caixa Geral de Depósitos (CGD) recapitalized; ongoing sale of Novo Banco; Banco Comercial Português (BCP) received a large capital injection; Banco Português de Investimento (BPI) taken over by CaixaBank.
- Key recent outcomes:
  - Headline fiscal deficit fell to 2 percent of GDP in 2016.
  - Household savings rate fell below 4 percent in the first quarter.
  - Unemployment rate fell to 8.8 percent in the second quarter of 2017 from 10.8 percent a year ago.
  - Twelve-month core inflation at 1 percent in July.
  - Staff projects real GDP growth to accelerate to around 2.5 percent in 2017, easing to 2 percent in 2018.

### Macroeconomic developments and investment
- Growth drivers and dynamics:
  - Export and investment pickup since mid-2016, alongside continued growth in private consumption.
  - Tourism remains a key growth driver; construction pickup driven by tourism-related renovation and nonresident residential purchases (Lisbon and Porto).
  - House prices increased by 15 percent in cumulative terms over the past two years through end-March, now exceeding the previous peak prior to 2010.
  - Investment in machinery and equipment has picked up, financed primarily through retained earnings as companies used declines in unit labor costs.
- Credit and lending patterns:
  - Total credit granted by resident financial institutions to the private sector fell 4 percent in the twelve months through June.
  - Corporate credit fell 7 percent in June (y/y).
  - New lending pickup concentrated in mortgages and consumer loans, supporting private consumption and housing prices.
- Investment composition and constraints:
  - Recent recovery in investment supported by tourism-related construction and capital replenishment associated with depreciation.
  - Corporates have financed much of the recent investment via retained earnings; sustained further investment growth likely requires increased bank lending.

### External sector and tourism
- Current account and exports:
  - Current account on track to record a surplus in 2017 as exports pick up and tourism grows, partly offset by higher imports.
  - Non-fuel goods’ exports rose 10 percent during January-June (y/y) compared with 2.5 percent during 2016.
  - Tourism sector: average annual growth in tourism revenues of 11.1 percent during 2014-2016.
- External positions:
  - Net international investment position improved from 118 percent of GDP at end-2014 to 105 percent of GDP at end-2016.

### Financial markets and monetary support
- Sovereign yields and market sentiment:
  - Spreads on 10-year Portuguese bonds vis-à-vis Germany narrowed by 150 basis points from mid-March to around 235 basis points at the end of July.
  - Spreads relative to other southern European economies also narrowed considerably in 2017.
  - Demand from retail investors remained strong; authorities expanded issuance of the five-year retail bond introduced in 2016.
- ECB purchases and market support:
  - The ECB’s average monthly purchases of Portuguese debt are set to decline by roughly 40-50 percent in 2017.
  - ECB purchases will continue to offset about 90 percent of Portugal’s net bond issuance and more than 40 percent of gross bond issuance in 2017.

### Labor costs, competitiveness, and phases of the recovery
- Three recovery phases identified by staff:
  1. Sharp decline in unit labor costs (ULCs) as employment fell more than output during the downturn.
  2. Competitiveness gains translated into a strong recovery in employment and output, exerting downward pressure on ULCs.
  3. ULCs now rising: ULCs rose by 1.7 percent on average in the twelve months through March (y/y) as wages outpaced productivity and labor markets tightened in key sectors.
- Implication: Rising ULCs may weigh on corporate savings and limit firms’ ability to continue financing investment without greater bank financing.

### Growth potential, vulnerabilities, and medium-term outlook
- Structural challenge:
  - Low potential growth and high public and private debt, with large annual financing needs, create medium-term vulnerability to shocks.
  - Breaking the cycle of weak banks, high NPLs, and low investment is essential to raise medium-term growth.
- Staff medium-term projections and scenarios:
  - Without more ambitious structural reforms, medium-term growth expected to converge to staff’s estimated potential growth rate of 1.2 percent.
  - Historical average annual growth was 0.8 percent during 2000-2010.
  - Staff calculations show that increasing potential growth to 2 percent by 2021 (in line with the authorities’ medium-term framework) would require average annual investment growth of roughly 6½ percent, assuming total factor productivity continues to rise at the current pace.
- Risks:
  - Near-term risks broadly balanced; longer-term risks tilted to the downside.
  - Upside: Stronger-than-expected EU recovery and large automobile industry investments coming online in next two years.
  - Downside: Moderation in tourism growth after a rapid increase in arrivals (one-third increase over past three years); record low household savings rate likely to rise as households rebuild savings; risk of structurally weak growth in key trading partners.
- Financing environment:
  - Financing environment likely to be less benign as monetary accommodation is reduced.
  - Relatively favorable maturity structure limits near-term impact of rising yields, but debt redemptions will rise significantly in 2021.
  - Less supportive financing conditions increase risk of sudden market fluctuations from domestic surprises or external shocks.

### Policy messages and priorities
- Fiscal policy and public debt:
  - The pickup in growth puts the headline fiscal deficit target of 1.5 percent of GDP for the year well within reach.
  - In structural terms, a modest loosening of the fiscal stance is projected, as in the past two years.
  - Durable structural fiscal consolidation is essential to ensure the sustainability of public finances given high public debt and likely less benign financing conditions in the future.
- Financial sector and banks:
  - Recent capital increases improved financial stability; steps to increase capital should be followed by ambitious efforts to clean banks’ balance sheets.
  - Large stock of NPLs is likely to limit banks’ ability to finance future growth and leaves them vulnerable to downside risks.
  - Ambitious efforts by banks to strengthen balance sheets would improve intermediation of savings into productive investment.
- Structural reforms and investment:
  - Raising growth potential requires further structural reforms to boost investment and productivity, and increased bank lending for investment.
  - Sustaining higher investment will require improved financial sector intermediation, minimizing fiscal risks, and addressing persistent structural rigidities.

*International Monetary Fund staff, Executive Summary (August 16, 2017).*

### 4.7 billion by mid-2019. This would leave Portugal’s credit outstanding to the Fund at SDR 3.9 billion, above the SDR

### cr17278 - 4.7 billion by mid-2019. This would leave Portugal’s credit outstanding to the Fund at SDR 3.9 billion, above the SDR

### External position and competitiveness
- Staff assessment: current account shortfall of about 2-4 percent of GDP relative to the surplus needed to meaningfully reduce the NIIP stock.
- EBA model-based estimates: current account gap of less than 1 percent, a deterioration of about ½ percentage point of GDP.
- REER assessment: overvaluation of 5-10 percent per EBA results.
- Policy implication: sustained fiscal consolidation and structural reforms are required to improve competitiveness and potential growth to address the large NIIP deficit.

### Authorities’ views on growth and external adjustment
- Authorities’ assessment: structural changes have put Portugal on a higher growth path due to higher skill levels of new entrants and mid-career training initiatives; expect sustained increases in productivity growth.
- Financial sector: authorities believe recent developments will improve lending decisions and capital allocation; access to financing not seen as a constraint on investment.
- Exports: authorities highlight export performance and market share gains, competing in higher value added segments (e.g., textiles) via quality and product differentiation; see limited relationship between ULCs and export competitiveness.
- Debt management: authorities view the ECB’s PSPP as now playing a more limited role; expect any tapering to be gradual. They cite a large cash buffer at about 50 percent of financing needs over the next 12 months and ongoing efforts to lengthen maturities.

### Financial sector developments and challenges
- Recent capital injections and transactions:
  - CGD subordinated debt issue of €0.5 billion at end-March (coupon 10.75 percent); second tranche scheduled in 18 months for €0.43 billion.
  - Agreement to sell a 75 percent stake in Novo Banco to Lone Star in exchange for a €1 billion capital injection (sale conditional on further terms and approvals, including a €0.5 billion voluntary conversion).
  - BCP capital injection of €1.5 billion.
  - BPI taken over by CaixaBank.
- Bank balance-sheet indicators (EBA definition, end-March 2017):
  - NPLs at 16.4 percent of total loans.
  - Corporate NPLs at 29.0 percent.
  - Household loans for house purchase NPLs at 6.7 percent.
  - Consumer and other loans NPLs at 10.0 percent.
  - Coverage ratio increased to 45.5 percent of NPLs as of end-March 2017.
- Operational issues: low interest margins, higher loan loss impairments, and remaining weak profitability despite cost reductions.

### Staff recommendations for the banking sector
- Boost internal capital generation:
  - Continue cost-cutting (downsizing domestic and foreign networks, divestment of non-core assets and business lines, reducing overhead).
  - Diversify income toward fee-generating financial products and services to raise earnings.
- Remove impediments to NPL resolution:
  - Implement recent measures to improve the legal framework: facilitate workouts for distressed but viable SMEs; improve judicial and extra-judicial insolvency and recovery processes and collateral enforcement; remove tax disincentives to impairment and write-offs; remove disincentives for public creditors to participate in debt workouts; develop the NPL market.
  - Encourage banks to increase provisioning coverage to incentivize NPL sales to third parties.
  - Create an enhanced creditors’ coordination platform and pursue legislative efforts to facilitate corporate debt restructuring.
  - Explore a private sector-led Asset Management Company as an alternative market-wide solution, considering constraints (limited fiscal space, BRRD and State-aid rules, lengthy foreclosure processes, difficulty assuring market-based pricing of troubled assets).
- Address forthcoming regulatory challenges:
  - Prepare for IFRS 9: provisions based on expected losses.
  - Anticipate fully loaded Basel III implications and likely need for new equity issuance.
  - Prepare for MREL targets, which will likely require Portuguese banks to tap wholesale markets to comply with the minimum required loss-absorbing liabilities.

### Authorities’ views on banking sector adjustment
- Authorities and European counterparts: view that with immediate capital needs addressed, balance-sheet cleanup will proceed gradually.
- Emphasis on:
  - Long phasing-in of Basel III and IFRS 9 transition period allowing smooth compliance.
  - NPL workout initiatives and banks’ NPL reduction plans as positive governance changes.
  - NPL platform expected to facilitate coordination on common exposures.
  - Caution against NPL fire sales that would destroy bank capital.
  - Vigilance about risks from increased new lending to households and cautioning banks against loosening lending standards.
- Uncertainty: cost of MREL cannot yet be estimated reliably.

### Fiscal policy outlook and recommendations
- Fiscal targets and recent performance:
  - Headline fiscal deficit target for the year: 1.5 percent of GDP appears within reach.
  - Real GDP growth projection: 2.5 percent (compared with 1.8 percent assumed in the Stability Program).
  - Public debt projection: decline from 130.3 percent of GDP at end-2016 to around 126 percent at end-2017.
  - Authorities’ Stability Program target: headline deficit of 1 percent of GDP for 2018.
  - Authorities’ cash buffer and prepayments: additional planned prepayments to the IMF expected for 2018-2019 (projected repayments to the IMF include additional advanced repurchases planned for 2018-2019).
- Staff advice:
  - Structural fiscal consolidation remains essential to keep public debt on a firmly downward trajectory after 2017.
  - For 2018, staff would advise a structural primary adjustment of 0.5 percent of GDP, in line with Portugal’s commitments under the Stability and Growth Pact.
  - Apply any revenue overperformance to a faster reduction in public debt.
- Suggested fiscal consolidation focus:
  - Durable spending reform to reduce overlap and improve efficiency of public spending; protect public investment.
  - Contain the public wage bill:
    - Need stronger wage bill planning and public sector restructuring to adjust public employment and generate planned fiscal savings.
    - Contain public compensation by streamlining allowances and improving equity among civil servants.
  - Improve efficiency of social spending:
    - Redistributive power of social spending below EU average.
    - Priority: improve labor prospects for young adults and rebalance fiscal redistribution toward the youth.
  - Revisit pension reforms to reduce grandfathering:
    - Authorities’ planned changes expected to cost less than 0.2 percent of GDP.
    - Broader reform needed given pension spending at 15.6 percent of GDP in 2014.
    - Current reforms backloaded; pension benefit ratio starts being reduced only after 2025, with large share of adjustment borne by current working-age population.

### Key figures and charts referenced
- Portugal’s credit outstanding to the Fund at SDR 3.9 billion.
- SDR 1.5 billion threshold for Post-Program Monitoring.
- Public debt: 130.3 percent of GDP (end-2016); around 126 percent (end-2017 projection).
- NPL ratios and coverage as of end-March 2017: 16.4 percent (total NPLs), 29.0 percent (corporate), 6.7 percent (house purchase), 10.0 percent (consumer/other), 45.5 percent coverage.
- Recent capital transactions and sizes: €0.5 billion (CGD subordinated debt), €0.43 billion (second tranche), €1 billion (Novo Banco injection), €1.5 billion (BCP injection).
- Pension spending: 15.6 percent of GDP in 2014.
- Recommended structural primary adjustment for 2018: 0.5 percent of GDP.

*International Monetary Fund. Portugal: selected extracts on external position, financial sector, and fiscal policy.*

### 22.      The authorities’ structural agenda focuses on improving the comparatively low skill

### 22.      The authorities’ structural agenda focuses on improving the comparatively low skill 

### Authorities’ structural agenda
- Key components of the National Reform Program:
  - (i) Development of human capital, through better formal education, lifelong learning and improvements in information technology skills;
  - (ii) Recapitalization of the corporate sector, including incentives to increase equity and reduce reliance on bank financing;
  - (iii) Modernization of the public sector, including simplification of administrative and licensing procedures for enterprises;
  - (iv) Encouraging R&D, innovation and entrepreneurship.

### Staff views — focus on removing investment impediments
- General assessment:
  - The current upswing and supportive financing conditions provide a favorable window to address impediments to higher investment.
  - Structural reforms should focus on bottlenecks that adversely impact investors’ perceptions of the business environment, including rigidities in the labor market, an unpredictable regulatory environment and inefficient judicial processes.

- a. Labor market flexibility:
  - As a member of a currency union with limited fiscal space, it is essential that labor markets have sufficient flexibility for adjustment.
  - Program-era policy changes to make hiring and collective bargaining more flexible should be safeguarded.
  - The gap between temporary and permanent contracts should be addressed by making permanent contracts more flexible rather than simply restricting temporary contracts.
  - Policies should aim at facilitating the movement of labor across firms and sectors without excessively penalizing the workforce.

- b. Judicial sector efficiency:
  - Official data on enforcement and insolvency cases show a positive trend in recent years, but anecdotal evidence suggests frequent delays and low pay-outs continue to discourage creditors from initiating enforcement and liquidation processes.
  - The mission advised the authorities to commission an in-depth survey on the efficiency of the judicial system by an outside firm to develop an accurate assessment of the reality on the ground.
  - The decree law with changes in the codes of commercial societies and of firms’ insolvency and liquidation under the Capitalizar program is a welcome step to increase judicial sector efficiency to help the corporate sector to deleverage.

- c. Corporate debt overhang:
  - The corporate sector continues to deleverage at a slow pace.
  - Speeding up NPL resolution would help reduce the debt overhang.
  - More than 50 percent of outstanding debt is owed to non-bank creditors.
  - Corporate governance reforms are needed to encourage firm owners to retain more earnings and inject new equity into their companies.
  - To reduce the tax debt bias, the authorities could build on their on-going efforts to offset the distortion of the deductibility of debt interest.

- d. Public sector payments discipline:
  - The authorities reduced the stock of outstanding arrears to 0.5 percent of GDP at end-2016.
  - Arrears continued to accumulate in early 2017, particularly in the health sector, with an increase of 0.1 percent of GDP through end-June.
  - Recommendation: implement a more forceful strategy to prevent new arrears in the hospital sector by reviewing budgeting policy, addressing inefficiencies, and further strengthening commitment controls.
  - Corporates identify lack of public sector payments discipline as an impediment to new projects because it ties up their resources for extended periods.

### Authorities’ views
- The authorities were confident that ongoing initiatives would support stronger labor productivity and address financing constraints in the corporate sector.
- They considered the recent pickup in growth an affirmation of the significant structural changes in the economy in recent years.
- They highlighted Capitalizar and Semente programs as key initiatives to alleviate financing constraints in the corporate sector and support increased investment.
- They noted concerns about labor market segmentation but emphasized that any fine-tuning of policies in this area would not constitute a change in the direction of reforms and were intended to address social inequities that had emerged from the erosion of labor protection following the financial crisis.

### Staff appraisal — macro-financial assessment and policy priorities
- Progress noted:
  - Notable progress in addressing near-term fiscal and financial sector risks highlighted in last year’s Article IV consultation.
  - Portugal’s exit from the Excessive Deficit Procedure and marked improvement in stability and confidence in the banking system have bolstered investor confidence and contributed to a sharp narrowing in sovereign debt spreads since mid-March.

- Near-term growth:
  - The near-term growth outlook has improved as the ongoing recovery gains momentum.
  - Tourism remains a key driver of growth, with nonresident inflows driving a pickup in tourism-related construction and renovation of rental properties.
  - There has been a broad-based pickup in exports in recent quarters, supported by the euro area recovery.

- Medium-term risks to the recovery:
  - The current recovery is expected to moderate over the medium-term without additional financing to support a sustained increase in the level of investment.
  - Tourism growth is likely to moderate: the number of arrivals increased by one-third over the past three years.
  - Recovery in investment and growth in exports has been driven by past declines in unit labor costs which are now being reversed.
  - The inability of the banking system to provide credit to finance investment as labor costs rise and earnings decline is likely to constrain firms’ ability to maintain the level of investment needed to sustain the recovery.

- Structural vulnerabilities and policy challenges:
  - Increasing Portugal’s growth potential is central to addressing significant vulnerabilities that weigh on the medium-term outlook.
  - High public and private debt leave Portugal vulnerable to a range of shocks over the medium-term; these are magnified by Portugal’s low potential growth.
  - The medium-term policy challenge remains to break the vicious circle between weak banks, high NPLs and low investment that continues to constrain medium-term growth.
  - Sustaining higher investment will require concerted efforts to improve financial sector intermediation, minimize fiscal risks and address persistent structural rigidities.

- Financial sector concerns:
  - The large stock of NPLs will continue to hinder effective intermediation of savings by the financial sector to productive investment.
  - Financial stability has improved after recent capital augmentations, but the gradual pace of cleaning banks’ balance sheets is likely to limit their ability to finance future growth and leave them vulnerable to downside risks.
  - Total capital in the banking system still appears low given the burden of legacy NPLs and upcoming regulatory hurdles, highlighting the need for internal capital generation to maintain appropriate buffers.

- Fiscal policy:
  - Sustained fiscal consolidation is needed to ensure a firmly downward trajectory for public debt over the medium-term.
  - The pickup in growth and supportive financial market conditions facilitated a reduction in the headline fiscal deficit during 2016-2017 despite a modest loosening in the underlying fiscal stance.
  - Public debt remains a significant vulnerability and is set to remain elevated over the medium-term.
  - The current cyclical conditions provide a favorable opportunity for more ambitious structural consolidation and a faster reduction in public debt.
  - A fiscal consolidation based on durable expenditure reform would likely prove more sustainable and supportive of growth, and help reinforce investors’ perceptions of the predictability of the tax regime over the investment horizon.

- Policy priorities reiterated:
  - Further structural reforms to address impediments to private long-term investment, focusing on labor market rigidities, inefficient judicial processes, an unpredictable regulatory environment and delays in public sector payments.
  - Improve financial sector resilience, ensure durable fiscal consolidation and raise potential growth to maintain investor confidence and reduce medium-term vulnerabilities.

- Financing environment:
  - Near-term financing risks have receded, but the financing environment is likely to be less benign over the medium term.
  - The relatively favorable maturity structure of Portugal’s public debt limits the near-term impact of rising yields, but a less supportive financing environment increases the risk of sudden fluctuations in market conditions in the event of negative domestic surprises or external shocks.
  - The large cash buffer leaves Portugal well positioned to withstand temporary market fluctuations, but financing needs remain large and will rise in the medium-term.
  - Borrowing costs are expected to remain manageable under the baseline of a gradual reduction in monetary accommodation.

- Procedural recommendation:
  - Staff recommends the next Article IV consultation be held on the standard 12-month cycle.

### Box 1 — Investment and the Medium-Term Growth Outlook (summary)
- Historical growth:
  - Growth in Portugal has been moderate over the past two decades — the average growth rate of real GDP from 1996 to 2016 was 1.2 percent.

- Investment and growth targets:
  - Compared with euro area peers, the low level of investment stands out as a key factor contributing to low real GDP growth rates.
  - To derive the average annual growth rates of investment needed to achieve the real GDP growth path envisaged in the 2017 Stability Program, as well as the average real GDP growth rates of 2.5 percent during 2017-22, a standard Cobb-Douglas production function is utilized under varying assumptions of annual TFP growth; the lower the rate of TFP growth, the higher the rate of investment growth required to achieve the GDP growth target.

- Specific numbers and implications:
  - The average annual growth rate of investment in the Stability Program is 4.9 percent, implying that the TFP should grow at about 0.2 percent per year.
  - Staff estimates show the average TFP growth in the past two decades was negative, at -0.26 percent.

*IMF staff report (cr17278) — chapter on structural agenda, staff views, authorities’ views, and staff appraisal*

### conclusion that Portugal’s economic growth during the pre-crisis boom was largely attributed to factor

### cr17278 - conclusion that Portugal’s economic growth during the pre-crisis boom was largely attributed to factor

### Main finding: growth attribution
- Portugal’s economic growth during the pre-crisis boom was largely attributed to factor accumulation rather than productivity growth.

### Investment requirements and scenarios
- It is likely that the growth rate of investment must significantly exceed the projected 4.9 percent in order to achieve the real GDP growth path envisaged in the 2017 Stability Program.
- If the annual TFP growth could accelerate to 0.4 percent, then an around 4 percent growth rate of investment would suffice.

### Policy recommendations (to raise both investment and productivity)
- Foster human capital accumulation.
- Increase labor market flexibility.
- Improve judicial sector efficiency.
- Reduce corporate debt overhang.
- Enhance public sector payments discipline.
- Reduce energy costs.

*Source: IMF staff analysis (Selected Issues Paper, “Investment and the Medium-Term Growth Outlook”; material from cr17278).*

### Annex I. Public Debt Sustainability Analysis (DSA)

### Annex I. Public Debt Sustainability Analysis (DSA)

### A. Baseline Scenario
- Staff’s baseline projects public debt to decline to 125.7 percent of GDP at end-2017, the lowest level since 2011, reflecting a decline in the headline deficit and improved growth dynamics with real GDP growth expected to accelerate to 2.5 percent in 2017.
- Public debt is projected to continue a steady decline through 2022, but remain elevated at 114 percent of GDP in 2022.
- The headline fiscal deficit is projected to stabilize at around 1.5 percent of GDP over the medium term.
- The projected debt reduction is larger than at the time of the 5th PPM, primarily reflecting the upward revision to real GDP growth for 2017-20.
- Deposits are expected to decline in 2017 to fund the recapitalization of CGD; further drawdown of cash deposits from 2018–22 is projected to be modest, reflecting the authorities’ intention to maintain cover for 6 months’ refinancing needs.
- Under staff’s baseline, the fiscal primary balance is expected to stabilize at around 2.5 percent of GDP over the medium term.

### B. Risk Assessment
- Portugal’s debt ratio already exceeds the debt burden benchmark for advanced economies of 85 percent of GDP under the baseline scenario.
- Public gross financing needs fall below the relevant benchmark of 20 percent of GDP during the projection period due to longer-term issuance and shorter-term debt buybacks (including advanced repurchases to the Fund) that moderate near-term refinancing needs and smooth the redemption profile.
- Debt profile risks: medium to low in terms of market perception, projected change in short-term debt, and share of public debt held by nonresidents.
- Standardized contingent liabilities shock from the MAC DSA template does not apply because bank vulnerabilities are below the relevant thresholds identified by the MAC DSA template; instead a customized contingent liabilities shock is used given risks from SOEs and PPPs.
- Note: the total (public and private) external financing requirements exceed the relevant benchmark under the baseline; this figure includes non-residents bank deposits, accounting for about 45 percent of GDP.

### C. Realism of Baseline Assumptions and Alternative Scenarios
- Staff notes Portugal’s growth forecast track record shows a relatively large median error compared with other countries with Fund-supported programs, especially during the pre-crisis period.
- Staff’s updated projection assumes a potential growth rate with achievement of a growth rate of 1.2 percent over the medium term, consistent with moderate growth convergence.
- The authorities’ Stability Program for 2017–21 envisages a reduction in public debt to 109.4 percent of GDP by 2021, based on an assumed annual real GDP growth of 2.0 percent in 2017–21; staff’s baseline assumes average annual growth of 1.7 percent over the same period.
- Staff highlights that if growth turns out lower than projected (e.g., reversal of structural reforms or external demand shocks), the rate of debt decline would significantly slow; protracted negative inflation could further impede balance sheet repair (referenced in customized deflation scenario).

### D. Stress Test — Key Findings
- Growth shock: A shock that lowers output by nearly 4.5 percentage points in 2017–18 (and inflation by a cumulative 1 percentage point) would see debt peak at about 130 percent of GDP in 2019, 11 percentage points higher than baseline.
- Deflation scenario: A sharper growth shock that lowers output by 5½ percentage points in 2017–18 with deflationary pressures (inflation lower by cumulative 4 percentage points) would push debt to 139 percent of GDP by 2019 and keep it close to that level over the medium term.
- Interest rate shock: A sustained interest rate shock of 280 basis points throughout the projection period would have limited immediate effect due to long-term maturity of debt but would slow debt decline so that by 2022 the debt-to-GDP ratio is about 3 points higher compared with baseline.
- Contingent liabilities shock: Under a severe scenario staff estimates further contingent liabilities could potentially materialize of about 10 percent of GDP (due to financial sector risks, SOEs, and State guarantees); such a shock would push the 2018 debt ratio to 130 percent of GDP.
- Combined severe shock: A severe combined shock incorporating the macro-fiscal and contingent liabilities adverse scenarios would raise debt to 139 percent of GDP in 2019 and keep it at that level over the medium term.
- Stress test parameter examples and outcomes (from figures and tables):
  - Baseline real GDP growth: 2.5 (2017), 2.0 (2018), 1.7 (2019), 1.5 (2020), 1.2 (2021), 1.2 (2022).
  - Baseline inflation (GDP deflator): 2.2 (2017), 1.7 (2018), 1.6 (2019), 1.8 (2020–2022).
  - Baseline effective interest rate: 3.3 (2017), 3.3 (2018), 3.4 (2019), 3.4 (2020), 3.4 (2021), 3.5 (2022).
  - Under the deflation scenario: inflation paths include -0.4 (2018) and -0.5 (2019) relative to baseline.

### E. Policy Implications and Staff Recommendations
- Durable structural fiscal consolidation is critical to anchor debt on a downward-sloping path, boost policy credibility, and strengthen resilience to reversals in market sentiment.
- Given vulnerability to primary balance shocks, maintaining primary balances that exceed the debt-stabilizing threshold is necessary; the baseline assumes a primary balance stabilizing at around 2.5 percent of GDP.
- Continued attention to mitigating contingent liability risks (financial sector, SOEs, State guarantees) is important given the potential for a 10 percent of GDP shock under a severe scenario.
- Debt management that lengthens maturities and preserves a cash buffer (e.g., cover for 6 months’ refinancing needs) helps moderate gross financing needs and smooth redemption profiles.

### F. Authorities’ Views
- Authorities noted divergence between their medium-term outlook and staff’s baseline and were optimistic that recent reforms have laid the foundation for stronger export-oriented growth supporting larger medium-term debt improvement than staff projects.
- Authorities reiterated commitment to medium-term fiscal consolidation as in their 2017 Stability Program and expressed confidence in their record of fiscal adjustment and reform boosting credibility with investors.
- Authorities emphasized progress in reducing borrowing costs and considered the maturity structure of public debt and large cash buffer to provide resilience to fluctuations in market conditions that might result from tapering of PSPP.

*IMF staff Annex I. Public Debt Sustainability Analysis (DSA).*

### Annex II. Risk Assessment Matrix

### Annex II. Risk Assessment Matrix

### Loss of investor confidence due to reform reversals or other negative surprises
- Relative Likelihood: Medium
- Impact: High
- Risks and manifestations:
  - Increase in sovereign bonds yields and reduction in foreign direct investment.
  - Tighter than expected ECB policies, including a reduction in asset purchases.
  - Significant funding distress; higher public and private borrowing costs.
- Policy response:
  - Strengthen policy buffers and avoid backtracking on reforms to prevent negative domestic shocks.
  - Step up efforts to implement policies that supports growth, lasting fiscal adjustment, and a strong banking sector, which all would contributing to shoring up investor confidence, and ease financing conditions and restraints.

### Financial distress in one or more banks
- Relative Likelihood: Medium
- Impact: High
- Risks and manifestations:
  - Loss of confidence in the banking system, resulting in potentially high fiscal costs.
- Policy response:
  - Proactive bank supervision to ensure balance sheet clean-up, a build-up of capital buffers in banks and of fiscal buffers.
  - Strengthen oversight of banks’ risk management practices.
  - Shore up the banks using the existing toolkit, while ensuring public debt dynamics are not compromised.

### Policy and geopolitical uncertainties
- Relative Likelihood: High
- Impact: High
- Risks and manifestations:
  - Policy uncertainty and divergence. Two-sided risks to U.S. growth with difficult-to-predict policies and global spillovers.
  - In Europe, uncertainty associated with negotiating post-Brexit arrangements and with upcoming major elections.
  - Policy divergence could lead to rising global imbalances and exacerbate exchange rate and capital flow volatility.
  - Increased investor uncertainty, exacerbating low investment, weak productivity and undermining cyclical recovery.
  - Lower growth due to trade barriers.
  - Escalation of euro skepticism, leading to less cooperation and a reversal of integration.
- Policy response:
  - Accelerate structural reforms to support investment and growth.
  - Strengthen fiscal policy adjustment to support investor confidence.
  - Step up efforts to clean up corporate and bank balance sheets.

### Financial conditions: Stronger US dollar, higher interest rates, and European bank distress
- Relative Likelihood: High (for strengthening US dollar/higher rates); Medium (for European bank distress)
- Impact: High
- Risks and manifestations:
  - Significant further strengthening of the US dollar and/or higher interest rates. As investors reassess policy fundamentals, as term premia decompress, or if there is a more rapid Fed normalization, leveraged firms, lower-rated sovereigns and those with un-hedged dollar exposures could come under stress.
  - Could also result in capital account pressures for some economies.
  - Higher borrowing costs for the public and private sector as the ECB normalizes monetary policy.
  - Loss of market confidence, leading to wider spreads.
  - Less favorable financial conditions as global conditions tighten.
  - European bank distress: Strained bank balance sheets amid a weak profitability outlook could lead to financial distress in one or more major banks with possible knock-on effects on the broader financial sector and for sovereign yields in vulnerable economies.
  - Given its high corporate and private debt levels, Portugal would be highly susceptible to financial contagion. The result would be a heightened financial stress in the Portuguese banking system, as balance sheet fragilities in both banking and corporate sectors are still significant.
- Policy response:
  - Step up efforts to implement policies that supports growth, lasting fiscal adjustment, and a strong banking sector, which all would contributing to shoring up investor confidence, and ease financing conditions and restraints.
  - Proactive bank supervision to ensure balance sheet clean-up, a build-up of capital buffers in banks and of fiscal buffers. Strengthen oversight of banks’ risk management practices.
  - Shore up the banks using the existing toolkit, while ensuring public debt dynamics are not compromised.

### Weaker-than-expected global growth
- Relative Likelihood: High (US, euro area, and Japan); Medium (Emerging Markets)
- Impact: High
- Risks and manifestations:
  - Structurally weak growth in key advanced and emerging economies: Low productivity growth (U.S., the Euro Area, and Japan), a failure to fully address crisis legacies and undertake structural reforms, and persistently low inflation (the Euro Area, and Japan) undermine medium-term growth in advanced economies (high likelihood).
  - Resource misallocation and policy missteps, including insufficient reforms, exacerbate declining productivity growth in emerging markets (medium likelihood).
  - Low growth would imperil debt dynamics in all sectors, with the euro area accounting for 60 percent of total exports putting the current account balance and IIP at risk.
- Policy response:
  - Step up structural reforms to improve competitiveness and reduce debt overhang.
  - Step up efforts to clean up corporate and bank balance sheets, to minimize drag on investment and growth.

### Lower energy prices
- Relative Likelihood: Low
- Impact: Medium
- Risks and manifestations:
  - Production cuts by OPEC and other major producers may not materialize as agreed while other sources of supply could increase production.
  - A low fuel import bill is potentially offset by greater difficulties in Angola, a key economic and financial partner.
- Policy response:
  - Step up efforts to clean up corporate balance sheets, including the reduction of exposures to Angola.
  - Shore up the banks using the existing toolkit, while ensuring public debt dynamics are not compromised.
  - Renewed structural reform effort to expand exports to other markets.

*/* The Risk Assessment Matrix shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of the staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). */

### Annex III. External Stability Report

### Annex III. External Stability Report

### Overall Assessment
- The external position in Portugal in 2016 was weaker than that consistent with medium-term fundamentals and desirable policy settings.  
- In 2017 the CA is projected to deteriorate somewhat with rising import demand.  
- Despite strong improvement in the current account since the crisis, reaching a more sustainable NIIP position would require a weaker effective exchange rate.  
- The large negative NIIP comes with external vulnerabilities, including from valuation changes and the large gross financing needs from external debt.  
- Past debt management efforts to reduce sovereign external risk—smoothing the profile for redemptions and lengthening average maturity—have mitigated risk somewhat, although most recently the average residual maturity of non-EU-IMF loans have gone down slightly.  
- Portugal remains exposed to a loss in confidence by external investors.

### Foreign asset and liability position and trajectory
Background:
- The negative net international investment position (NIIP) declined from its peak in 2014 of 118 percent of GDP to 105 percent of GDP at the end of 2016.  
- This improvement has been driven by the reversal of the current account balance through the crisis, but offset by improving external debt valuations.  
- Gross external debt remains high at 215½ percent of GDP.  
- Both NIIP and gross external debt are expected to continue to decline, but at a decelerating rate over the medium-term as the current account moves to deficit.

Assessment:
- The large negative NIIP contributes to external vulnerabilities from valuation changes and large gross financing needs.  
- Debt management actions have reduced sovereign external risk but residual maturity of some loans has shortened recently.  
- Continued exposure to investor confidence shocks remains.

Potential policy responses:
- Sustained fiscal consolidation and structural reforms to improve Portugal’s competitiveness and potential growth.  
- Effective work out of longstanding NPLs, accelerated judicial procedures, reduced electricity costs and improved transport links to help drive investment.  
- Labor market reforms to better integrate the low-skilled and long-term unemployed while maintaining past reforms to collective bargaining to improve cost-side competitiveness.  
- Fiscal consolidation through high quality measures, using the remaining window of accommodative ECB monetary policies, to reduce net interest payments, facilitate external deleveraging, and boost investor confidence.

### Current account
Background:
- The Portuguese current account has been in a surplus since 2013 after an extended period of deficits in the range of 10 percent of GDP.  
- The current account registered a surplus of 0.8 percent of GDP in 2016.  
- The surplus is expected to moderate in 2017-19 and shift to a deficit beginning in 2020 as import growth outstrips export growth.

Assessment:
- EBA model-based estimates suggest a cyclically adjusted current account balance of -0.4 percent of GDP, compared to a norm of 0.4 percent of GDP, resulting in a negative current account gap of less than 1 percent.  
- Staff assesses the current account surplus to be insufficient given the large NIIP deficit that needs sustained downward trajectory.  
- Relative to a current account surplus of 2½ percent, and assuming continued capital account surpluses that would achieve a meaningful medium-term reduction in the NIIP deficit (bringing it to below 50 percent over the next 5 to 10 years), staff assesses a current account short fall of about 2-4 percent of GDP.  
- Key to strengthening the external position, including the high level of public debt, is sustained fiscal adjustment paired with structural reforms to support growth and investment, and continued efforts to address remaining financial sector challenges.

### Real exchange rate
Background:
- Both the CPI-based real effective exchange rate (REER) and the unit labor cost (ULC)-based REER are still well below their pre-crisis peaks—CPI-based REER 5½ percent below, and ULC-based REER 12 percent below.  
- Both REER measures have been on an appreciating trend since the post crisis low points in early 2015; appreciation around 3½ percent since then is limited, but continued trend would deteriorate competitiveness.

Assessment:
- The EBA’s index and level REER regression models indicate an overvaluation of 6½ and 5 percent respectively for 2016.  
- These metrics are at the lower end of what is needed, given current policies, to put the NIIP deficit on a decisive downward trajectory, which suggest an overvaluation of the REER in a range of 5 to 10 percent.  
- With appropriate structural, fiscal, and financial policies in place the adjustment could be less through price competitiveness and more through continued and sustained quality upgrades and innovation.

### Capital and financial accounts: flows and policy measures
Background:
- Financing conditions have eased dramatically since the resumption of sovereign market access in 2014.  
- Sovereign spreads to bunds were about 235 basis points at end-July.  
- Continued market concerns about the high level of public debt and significant reliance on ECB purchases under the PSPP persist.  
- Wholesale funding of banks has continued to decline.

Assessment:
- A current account surplus and ECB policy actions have helped support external financing rollover needs for the immediate future.  
- Further policy action will be needed over the medium term to maintain investor confidence and rule out negative equilibria.

### FX intervention and reserves level
Background:
- The euro has the status of a global reserve currency.

Assessment:
- Reserves held by the euro area are typically low relative to standard metrics, but the currency is free floating.

*IMF staff report Annex III, "External Stability Report."*

### 11.4 percent. This was associated with weak profitability (mainly stemming from the

### cr17278 - 11.4 percent. This was associated with weak profitability (mainly stemming from the

### Capital positions and profitability
- Banking system aggregate CET 1 ratio declined to 11.4 percent (associated with weak profitability, mainly stemming from the decrease in profits in Caixa Geral de Depósitos and the gradual elimination of transitional provisions for eligibility of own funds, as foreseen in CRD/CRR).
- The 2016 capital ratio decline was temporary: Caixa Geral de Depósitos and Banco Comercial Português conducted capital increase operations in early 2017, rising the banking system’s aggregate CET 1 ratio by 1.4 percentage points.
- Developments concerning the sale of Novo Banco and the takeover of BPI by CaixaBank, together with the capital increases, represent a significant improvement in the banking system and enhance the ability to deal with NPLs and favor market perception.

### Non-performing loans (NPLs) and impairment coverage
- NPL ratio trajectory:
  - 17.5 percent at end-2015
  - 17.2 percent at end-2016
  - 16.7 percent at end-March 2017
- Main drivers of NPL ratio decline:
  - Primarily write-offs
  - To a lesser extent, outright sales
  - These reductions more than compensated the denominator effect associated with the on-going deleveraging process
- Impairment coverage ratio increased from 41 percent in 2015 to 45 percent at end-March 2017.

### Loan portfolio composition and sectoral developments
- 2016 improvements in economic conditions across most non-financial sectors, particularly wholesale and retail trade, implying strengthened ability to service debt.
- Banks continued reshuffling portfolios toward sectors with better economic and financial indicators:
  - Share of loans to construction and real estate sectors declined.
  - Share of loans to wholesale and retail trade and manufacturing increased.
  - Loans to exporting companies (which post economic and financial indicators better than average) also increased their share in banks’ loan books.
- Households’ overall indebtedness continued to decline in 2016, with different trends by loan type:
  - Mortgages continued the downward path initiated in 2011.
  - Loans for consumption and other purposes posted a positive growth rate.
- Macroprudential monitoring:
  - Banco de Portugal, as Portuguese macro-prudential authority, is closely following the recent acceleration in consumer credit and the assessment of the risk of new credit flows.

### Policy stance and outlook
- The Portuguese Government will maintain its strong commitment towards sustainable economic growth, social cohesion and sound public finances.
- Structural reforms will continue to be implemented, based on lessons learned from previous efforts, with fine-tuning as needed and the launching of new initiatives to maintain the economy on a competitive and balanced growth path.
- The Portuguese authorities look forward to the next Article IV Consultation in 2018 as an opportunity to work closely with the IMF, deepen dialogue, and promote a closer mutual understanding.

*IMF country report (excerpt).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17278.pdf_