## EXECUTIVE SUMMARY

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### RECENT DEVELOPMENTS AND OUTLOOK
- Market access and monetary support:
  - Portugal returned to market financing on relatively favorable terms since the end of the Extended Fund Facility in 2014; ECB accommodative stance since early 2015 supported this return.
- Growth and labor market:
  - Growth: accelerated to 1.6 percent (year-on-year) in 2016Q3, up from 0.9 percent in the first half of 2016.
  - Staff projections: raised real GDP growth projections for 2016 and 2017 slightly to 1.3 percent; medium-term growth projection remains around 1.2 percent.
  - Private consumption: continued strong growth.
  - Net exports: improvement in 2016Q3, reflecting a strong tourist season.
  - Unemployment rate: fell to 10.5 percent (pre-crisis level).
  - Investment: showed tentative signs of recovery after prior deceleration.
- Inflation and competitiveness:
  - Headline inflation: between 0.5 and 1 percent (year-on-year).
  - Core inflation: slow upswing over the past two years.
  - Nontradables inflation: generally above tradables; ratio of non-tradable to tradable prices stayed elevated.
  - ULC-based real effective exchange rate: substantially below past peaks but improvement stalled with modest appreciation since mid-2015.
- External sector:
  - Current account: small surplus in 2016; overall surplus unchanged during January–October year-on-year.
  - Tourism revenues: rose more than 10 percent (year-on-year), on pace for the third consecutive year of double-digit growth.
  - Non-fuel goods exports: rose 1.8 percent during January–November (year-on-year), versus 4.6 percent in 2015.
- Credit and bank lending:
  - Credit outstanding to the private sector: fell 4 percent in the twelve months through November.
  - Corporate credit: fell 5 percent (twelve months through November).
  - New lending concentrated in consumer loans: have risen steadily since September 2015.
  - Low volume of new lending reflects banks’ risk aversion (weak asset quality) and weak demand from overleveraged corporates.
- Risks:
  - Near-term risks: broadly balanced; upside from investment and exports vs. downside from tighter financing conditions reducing consumption.
  - Medium-term constraints: corporate debt overhang, subdued bank lending, very low household savings rate limiting consumption-driven growth.

### CAPACITY TO REPAY THE FUND
- Overall assessment:
  - Portugal’s capacity to repay the Fund is expected to be adequate but fragile due to public debt dynamics and interlinked vulnerabilities (modest growth, high public debt, struggling banking system).
- Repurchases and cash buffer:
  - Advanced repurchases to the Fund: €4.5 billion in 2016; total of €12.9 billion since end of the program.
  - Next scheduled repurchase: not until April 2019.
  - Cash buffer at end-2016: €10.2 billion, sufficient to cover about 50 percent of next year’s projected financing need (excluding short-term rollover).
  - Authorities’ indicative target for cash buffer: 40-50 percent of the projected financing need for the next twelve months (excluding short-term rollover).
- Debt profile and issuance:
  - Average maturity of non-IMF/EU debt: improved to 6.6 years at end-2016 compared to 5.1 years at end-2013.
  - Issuance strategy: combination of longer-term issuance and shorter-term debt buybacks; increased issuance in domestic retail market in 2016 to diversify investor base.
- Reliance on ECB PSPP and market access risks:
  - PSPP purchases equaled the full amount of Portugal’s net bond issuance during 2015, and were more than double net issuance during 2016.
  - As of end-2016, ECB holdings of Portuguese sovereign bonds had increased to nearly one-third of total outstanding.
  - Sovereign spreads: spreads on 10-year Portuguese bonds vis-à-vis German bunds near 370 basis points in early 2017.
  - ECB December 8 announcement effects:
    - PSPP extended to end of 2017; minimum eligibility maturity lowered from 2 to 1 year; issuer limit of 33 percent not increased.
    - For Portugal, implies a reduction in monthly purchases by the ECB of roughly 40 percent or more from 2016.
    - Bond yields rose sharply on the announcement: benchmark ten-year yield near 4 percent, compared to 3.5 percent at the time of Portugal’s exit from the EFF in May 2014.
    - A syndicated 10-year issuance was placed in mid-January at a yield of 4.2 percent.
  - Portugal’s PSPP eligibility depends on maintaining an investment grade rating from DBRS; DBRS affirmed Portugal’s rating on October 21 but cited concern about weak growth outlook and noted rising yields could pose a risk.
- Funding needs and resilience:
  - Annual financing needs remain large, but longer average maturity and smoother redemption profile have increased resilience to a rise in borrowing costs.
  - Public DSA stress test: a sustained interest rate shock of 280 basis points would increase the debt-to-GDP ratio by 3 percentage points relative to the baseline by 2021.
- Staff view:
  - Adequate under a baseline of gradual reduction in monetary accommodation, but vulnerable to negative surprises (deterioration in macro outlook, external shocks such as US yield curve steepening, rising global yields, hard landing in China, or negative banking system shocks).
  - A negative banking shock could be particularly damaging by triggering a reinforcing cycle of restricted market financing and rising yields.
- Authorities’ view:
  - Confident recent macro and fiscal developments and steps to shore up the banking system would support continued favorable access to financing.
  - With longer-term yields near 4 percent, authorities acknowledged declining prospective interest savings from further Fund prepayments, and noted negative deposit rates increase cost of retaining a large cash buffer.

### POLICY DISCUSSIONS — FINANCIAL SECTOR (overview)
- Key challenges:
  - High stock of non-performing loans (NPLs), low bank profitability, and high operating costs constrain banks’ ability to lend adequately for new investment.
  - Weak bank lending contributes to weak investment and restrains growth; weaker growth in turn impedes banks’ ability to reduce NPLs and improve profitability, while hampering fiscal consolidation.
- Authorities’ stance and actions:
  - Authorities appear to be moving toward a more comprehensive approach to address high levels of NPLs, but plans to attract new capital into the banking system had yet to be completed at the time of the report.
  - Outlays for banking sector recapitalization continued to weigh on public debt dynamics.
- Policy priorities:
  - Ambitious efforts needed to improve financial sector resilience, ensure durable fiscal consolidation, and raise potential growth to reduce domestic risks.
  - Interlinkages between modest growth, large annual financing needs, and a challenged banking system leave Portugal vulnerable to shocks that could trigger changes in market sentiment and elevate borrowing costs.

### BANKING SECTOR: ASSET QUALITY, PROVISIONING, AND CAPITALIZATION
- NPLs and credit-at-risk:
  - Authorities estimated the outstanding stock of NPLs at €49 billion at end-2015 (27 percent of GDP), accounting for both overdue and unlikely-to-pay loans and representing 19 percent of total loans.
  - Credit at risk: rose to 12.6 percent of gross loans in 2016Q3, up from 12 percent at end-2015.
  - Corporate credit at risk: 20.2 percent in 2016Q3; credit at risk on household loans for house purchase: 6 percent.
- Capital adequacy and provisioning:
  - Portugal had the second lowest CET1 ratio in the EU at 12.3 percent of risk-weighted assets as of 2016Q3 (based on EBA data).
  - Total capital above regulatory requirements appears insufficient to tackle the likely capital shortfall if NPLs are fully provisioned for.
- Recent and planned bank actions:
  - CGD recapitalization preliminary agreement with EC: €5 billion recapitalization of CGD; public sector contribution €2.7 billion and a new subordinated debt issue of €0.5 billion; asset impairment review and market test expected in Q1 2017.
  - Novo Banco: negotiations to sell remain ongoing.
  - BCP: private capital injection with shareholders committed to increasing holdings by up to 30 percent of total shares; approvals received.
  - BPI takeover by CaixaBank: received regulatory approval.

### STAFF VIEWS ON BANKING-SECTOR STRATEGY
- Essential elements:
  - A predictable, time-bound and credible plan for write-off or restructuring of non-performing legacy assets across banks.
  - Strengthen internal governance and improve bank profitability, including further cutting costs.
  - Supervisors should ensure banks set ambitious targets for NPL reduction and incentivize moving NPLs off balance sheets by forcing increased coverage ratios and setting aside additional provisions for unlikely-to-pay loans that could be reported as non-distributable capital reserves.
  - Banks should adopt a more proactive focus on profitability, underpinned by additional cost reductions and efficiency gains.
- Rationale:
  - Predictability from a comprehensive strategy is necessary to attract new private capital; high public debt limits fiscal space to finance a ‘bad bank’.

### FISCAL POLICY: RECENT PERFORMANCE AND OUTLOOK
- Fiscal targets and outcomes:
  - Revised 2016 fiscal deficit target of 2.5 percent of GDP agreed with the European Commission appears within reach; further reduction to 1.6 percent of GDP planned in 2017.
  - 2016: sizable revenue shortfall and higher-than-planned spending on public wages likely offset by large under-execution of budgeted intermediate consumption and public investment.
- 2017 budget measures:
  - Full removal of the personal income tax surcharge and unfreezing of pension indexation at a total cost of 0.2 percent of GDP; primarily offset by hikes in property taxes and indirect taxes, and projected increases in non-tax revenues and recovery of outstanding tax debt.
- Impact of CGD recapitalization:
  - Public sector cash contribution under current plan: 1.5 percent of GDP.
  - Conversion of the state’s contingent convertible bonds and transfer of the state’s equity stake in a CGD subsidiary: additional 0.8 percent of GDP.
  - As a result, public debt rose to close to 131 percent of GDP at end-2016, with a modest decline to around 130 percent projected for end-2017.
  - Statistical treatment unclear; pending Eurostat ruling, operation included as a non-deficit increasing financial transaction in staff’s projections for 2017.
- Staff fiscal assessment:
  - 2017 budget depends largely on optimistic revenue projections, raising risks to execution.
  - Spending containment appears based primarily on untargeted measures and mid-year adjustments rather than durable reforms to improve efficiency.
  - Planned deficit reduction relies heavily on one-off revenues: repayment of a state guarantee called in 2010 (0.2 percent of GDP) and an increase in dividend payments from the central bank (0.2 percent of GDP).
  - Staff projects a fiscal deficit of 2.1 percent of GDP for 2017, an implied structural primary loosening of 0.1 percent of GDP (compared with the Article IV recommendation of a tightening of 0.6 percent).
  - Compression of capital spending could harm output; public investment was significantly lower than the EU average over the last five years and is likely to fall further.
  - Increase in arrears in January-November 2016, particularly in hospitals, adversely impacts private providers and is likely to increase spending pressures in 2017.

### STRUCTURAL REFORMS: PROGRESS AND PRIORITIES
- Status:
  - Implementation of macro-critical reforms has largely stalled over the past year, worsening the drag on potential growth from low investment and a shrinking labor force.
  - IMF staff 2015 survey and World Economic Forum 2016-17 GCR highlight structural gaps: public administration and judicial system effectiveness, payments discipline of public sector entities, insolvency and corporate debt restructuring frameworks, labor market flexibility.
- Authorities’ National Reform Program 2016-2020 priorities:
  - Development of human capital: better formal education, lifelong learning, improvements in managerial skills.
  - Recapitalization of the corporate sector: diversify financing sources, incentivize equity and reduce reliance on bank financing.
  - Modernization of the public sector: simplify administrative and licensing procedures for enterprises.
  - Encourage R&D, innovation and entrepreneurship.
- Minimum wage policy:
  - Authorities approved a further 5 percent increase in the minimum wage from 2017, above labor productivity growth; following increases of 4 percent in October 2014 and 5 percent in January 2016, implying a cumulative real increase of around 13 percent since mid-2014.
- Staff recommendations:
  - Reinvigorate structural reforms focusing on macro-critical gaps affecting the labor market and export competitiveness.
  - Link minimum wage increases to productivity to maintain competitiveness, given the ratio of minimum to median wages in Portugal remains well above the euro area average.
  - Bridge the gap between temporary and permanent contracts; ensure inclusive social dialogue.

### STAFF APPRAISAL: MACRO OUTLOOK AND PRIORITIES
- Outlook:
  - Pick-up in activity in 2016Q3; growth projections for 2016-17 upgraded slightly and near-term risks broadly balanced.
  - Medium-term growth outlook constrained by high debt and structural bottlenecks; consumption-based recovery likely to run out of steam due to depleted household savings and poor bank asset quality limiting financing for new investment.
- Debt and vulnerabilities:
  - Public debt dynamics remain fragile and vulnerable to changes in financing conditions.
  - Key priorities to reduce vulnerabilities:
    - Aggressively address NPLs and attract new bank capital.
    - Advance fiscal consolidation based on durable expenditure reform.
    - Reinvigorate the structural reform agenda.
- Financing environment:
  - Portugal maintained market access at relatively low but rising yields in 2016; financing environment may become less benign as euro-area monetary normalization is priced in.
  - Under the baseline of gradual reduction in monetary accommodation, the Fund considers Portugal’s capacity to repay adequate, but tangible risks of faster upward pressure on borrowing costs exist if negative surprises materialize.

*International Monetary Fund. EXECUTIVE SUMMARY (cr1758).*

### ANNEX I. PUBLIC DEBT SUSTAINABILITY ANALYSIS (DSA)

- Baseline scenario and key assumptions:
  - Fiscal deficit projection for 2016: 2.6 percent of GDP (revised down from 3 percent).
  - Public contribution to recapitalization of CGD: 1.5 percent of GDP.
  - Public gross debt projected to rise from 129.1 to 130.8 percent of GDP at end-2016.
  - Public debt net of central government deposits projected to decline slightly from 121.6 percent to 121.3 percent of GDP in 2016.
  - Headline fiscal deficit stabilizes at around 2 ¼ percent of GDP through 2018–21, with public debt modestly declining to 124.9 percent of GDP in 2021.
  - Deposits expected to decline in 2017 to fund CGD recapitalization; further drawdown from 2018–21 projected to be modest.
  - Potential proceeds from sale of financial sector assets (including Novo Banco) are not included in the baseline.
- Realism and alternative assumptions:
  - Staff’s medium-term average real GDP growth assumption: 1.2 percent.
  - Authorities’ Stability Program assumes annual real GDP growth of 2.0 percent in 2017–20 (versus staff’s 1.2 percent average for same period).
  - Authorities project public debt reduction to 110.3 percent of GDP by 2020 based on optimistic asset-sale and growth assumptions.
- Stress-test outcomes (2016–2021):
  - Growth shock: lowers output by nearly 4.5 percentage points in 2016–17 and inflation by cumulative 1 percentage point → debt peaks at about 139 percent of GDP in 2018 (9 percentage points higher than 2016 baseline).
  - Deflation scenario: lowers output by 5½ percentage points in 2016–17 and inflation lower by cumulative 4 percentage points → debt 148 percent of GDP by 2018 and close to that level over the medium term.
  - Sustained interest rate shock of 280 basis points: limited immediate effect; by 2021 debt-to-GDP about 3 points higher compared with the baseline.
  - Customized contingent liabilities shock: hypothetical further contingent liabilities of about 10 percent of GDP → 2017 debt ratio pushed to 140 percent of GDP.
  - Severe combined shock (macro-fiscal plus contingent liabilities): debt rises to 148 percent of GDP in 2018 and remains at that level over the medium term.
- Staff policy message:
  - Additional fiscal consolidation remains critical to anchor debt on a downward-sloping path, boost policy credibility, and strengthen resilience to reversals in market sentiment.
  - Debt dynamics remain vulnerable to adverse yet plausible macro-fiscal and contingent liabilities shocks, including possible need for further fiscal support for the financial sector.

*Source: IMF staff analysis, Annex I. Public Debt Sustainability Analysis (DSA).*

### ANNEX II. RISK ASSESSMENT MATRIX (RAM)

- Framework notes:
  - Relative likelihood classification: "low" <10 percent, "medium" 10–30 percent, "high" 30–50 percent.
  - "Short term" and "medium term": within 1 year and 3 years, respectively.
- Major risks, likelihoods, impacts, and prescribed policy responses:
  - Loss of investor confidence due to reform reversals or other negative surprises (including difficulties in the banking sector or loss of sole investment-grade rating)
    - Relative Likelihood: High
    - Impact: High
    - To minimize exposure: Strengthen policy buffers and avoid backtracking on reforms.
    - If materializes: Restore market access at favorable terms and ensure banks’ access to liquidity; take fiscal measures to ensure targets are met.
  - Financial distress in one or more banks, requiring intervention
    - Relative Likelihood: Medium
    - Impact: High
    - To minimize exposure: Proactive supervision, build capital and fiscal buffers, strengthen oversight of risk management.
    - If materializes: Shore up banks using existing toolkit while protecting public debt dynamics.
  - Economic fallout from political fragmentation (including post-Brexit negotiation uncertainty)
    - Relative Likelihood: Medium
    - Impact: Medium
    - Context: Portugal exports 3 percent of its GDP to the UK; UK tourists account for more than 17 percent of tourist receipts from foreigners in 2015.
    - If materializes: Encourage collaborative transitions and renewed reform efforts; ECB actions to rein in volatility.
  - Tighter and more volatile global financial conditions
    - Relative Likelihood: Medium
    - Impact: High
    - To minimize exposure: Shore up liquidity and capital buffers; encourage private savings; shrink private sector balance sheets.
    - If materializes: ECB policy actions to ensure market liquidity and orderly monetary transmission.
  - Weaker-than-expected global growth
    - Relative Likelihood: High for US, euro area, and Japan; Medium for Emerging Markets
    - Impact: High
    - To minimize exposure: Step up structural reforms to improve competitiveness and reduce debt overhang.
  - Persistently lower energy prices (supply factors)
    - Relative Likelihood: High
    - Impact: Medium
    - To minimize exposure: Clean up corporate balance sheets, reduce exposures to Angola.
- Policy priority synthesis from RAM:
  - Strengthen policy and fiscal buffers; maintain continuity of reforms; proactive bank supervision and targeted NPL tools; coordinate with ECB and international partners to manage spillovers; accelerate structural reforms.

*Source: Annex II. Risk Assessment Matrix and Statement by Mr. Carlo Cottarelli and Ms. Ines Lopes, Portugal, February 17, 2017.*

### OVERVIEW AND AUTHORITIES' ASSESSMENT (Statement by Mr. Carlo Cottarelli and Ms. Ines Lopes, February 17, 2017)
- Authorities’ priorities:
  - Recovery of households’ and firms’ incomes by reducing fiscal burden and improving labor market conditions.
  - Capitalization of firms to allow investment, job creation, and growth.
  - Address remaining challenges of the financial system to support investment recovery.
- Key 2016 achievements cited by authorities:
  - GDP increased by 1.4 percent according to INE.
  - Public deficit expected to be clearly below 2.3 percent of GDP.
  - Primary surplus expected to be above 2 percent.
  - Employment growth and unemployment close to single digits.
  - 2017 State Budget approved in November will continue consolidation and reform.
- Recent macro developments highlighted by authorities:
  - Q3 and Q4 2016: Portugal registered one of the highest GDP growth rates in the euro area.
  - Balance of goods and services: increase of €938 million up to November 2016 vs. same period in 2015.
  - Unemployment rate: 10.5 percent in Q4 2016, 1.7 percentage points below Q4 2015.
  - Private entrepreneurial investment rose 7.7 percent in Q3 2016.
  - Government 2017 expectations: GDP growth to accelerate to 1.5 percent; investment to increase by 3.1 percent; labor productivity to improve by 0.5 percent; unemployment to improve over the 10.3% target envisaged in the 2017 State Budget.
- Authorities’ fiscal views:
  - 2016 fiscal results: deficit expected to be clearly below 2.3 percent of GDP; primary surplus expected above 2.0 percent of GDP.
  - 2017 State Budget pillars include strict control of public expenditure, promotion of investment, fight against fraud and tax evasion, public administration reform, and support for National Reforms Program measures.
  - Government 2017 projections: public deficit decreasing to 1.6 percent of GDP; primary surplus increasing to 2.8 percent of GDP; public investment forecast to reach 2.2 percent of GDP in 2017.
  - Central administration deposits (cash-buffer) amounted to €10.2 billion at end-2016 (€6.6 billion in 2015).
- Structural reforms and implementation:
  - National Reforms Program (NRP) published end-March 2016 with 139 measures; 2/3 concluded or put in place in 2016; for remaining 1/3, 78% launched or ongoing.
  - National Skills Strategy to be supported by the OECD.
  - Early indicators show improvements in structural indexes; OECD’s PISA results: Portugal registered one of the largest improvements and is now above the OECD average in all indicators.
- Authorities’ conclusion:
  - Confident obligations towards the Fund will continue to be timely met.
  - Continued commitment to sustained and inclusive growth within growth-friendly fiscal consolidation.
  - Positive 2016 fiscal and economic results support continued efforts in 2017.
  - Authorities look forward to the sixth PPM mission to deepen dialogue with the Fund.

*Source: Annex II. Risk Assessment Matrix and Statement by Mr. Carlo Cottarelli and Ms. Ines Lopes, Portugal, February 17, 2017.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### RECENT DEVELOPMENTS AND OUTLOOK
- Portugal returned to market financing on relatively favorable terms since the end of the Extended Fund Facility in 2014; ECB accommodative stance since early 2015 supported this return.
- After a sluggish first half of 2016, growth accelerated to 1.6 percent (year-on-year) in 2016Q3, up from 0.9 percent in the first half of 2016.
- Growth drivers and labor market:
  - Private consumption: continued strong growth.
  - Net exports: improvement in 2016Q3, reflecting a strong tourist season.
  - Unemployment rate: fell to 10.5 percent (pre-crisis level).
  - Investment: showed tentative signs of recovery after prior deceleration.
- Inflation and competitiveness:
  - Headline inflation: between 0.5 and 1 percent (year-on-year).
  - Core inflation: slow upswing over the past two years.
  - Nontradables inflation: generally above tradables; ratio of non-tradable to tradable prices stayed elevated.
  - ULC-based real effective exchange rate: substantially below past peaks but improvement stalled with modest appreciation since mid-2015.
- External sector:
  - Current account: small surplus in 2016; overall surplus unchanged during January–October year-on-year.
  - Tourism revenues: rose more than 10 percent (year-on-year), on pace for the third consecutive year of double-digit growth.
  - Non-fuel goods exports: rose 1.8 percent during January–November (year-on-year), versus 4.6 percent in 2015.
- Bank lending and credit:
  - Credit outstanding to the private sector: fell 4 percent in the twelve months through November.
  - Corporate credit: fell 5 percent (twelve months through November).
  - New lending concentrated in consumer loans: have risen steadily since September 2015.
  - Low volume of new lending reflects banks’ risk aversion (weak asset quality) and weak demand from overleveraged corporates.
- Staff macro projections and risks:
  - Staff raised real GDP growth projections for 2016 and 2017 slightly to 1.3 percent.
  - Medium-term growth projection remains around 1.2 percent.
  - Near-term risks: broadly balanced; upside from investment and exports vs. downside from tighter financing conditions reducing consumption.
  - Medium-term constraints: corporate debt overhang, subdued bank lending, very low household savings rate limiting consumption-driven growth.
- Authorities’ macro assumptions for the 2017 budget:
  - Growth of 1.2 percent in 2016 and 1.5 percent in 2017; authorities viewed 2016Q3 acceleration as indicative of a sustained shift to a higher growth path.

### CAPACITY TO REPAY THE FUND
- Overall assessment:
  - Portugal’s capacity to repay the Fund is expected to be adequate but fragile due to public debt dynamics and interlinked vulnerabilities (modest growth, high public debt, struggling banking system).
- Repurchases and cash buffer:
  - Advanced repurchases to the Fund: €4.5 billion in 2016; total of €12.9 billion since end of the program.
  - Next scheduled repurchase: not until April 2019.
  - Cash buffer at end-2016: €10.2 billion, sufficient to cover about 50 percent of next year’s projected financing need (excluding short-term rollover).
  - Authorities’ indicative target for cash buffer: 40-50 percent of the projected financing need for the next twelve months (excluding short-term rollover).
- Debt profile and issuance:
  - Average maturity of non-IMF/EU debt: improved to 6.6 years at end-2016 compared to 5.1 years at end-2013.
  - Issuance strategy: combination of longer-term issuance and shorter-term debt buybacks; increased issuance in domestic retail market in 2016 to diversify investor base.
- Reliance on ECB PSPP and market access risks:
  - ECB sovereign debt purchases (PSPP) materially supported market access: purchases equaled the full amount of Portugal’s net bond issuance during 2015, and were more than double net issuance during 2016.
  - As of end-2016, ECB holdings of Portuguese sovereign bonds had increased to nearly one-third of total outstanding.
  - Sovereign spreads: spreads on 10-year Portuguese bonds vis-à-vis German bunds near 370 basis points in early 2017; spreads vis-à-vis other southern European economies continued to widen in late 2016 and early 2017.
  - ECB December 8 announcement effects:
    - PSPP extended to end of 2017; minimum eligibility maturity lowered from 2 to 1 year; issuer limit of 33 percent not increased.
    - For Portugal, implies a reduction in monthly purchases by the ECB of roughly 40 percent or more from 2016.
    - Bond yields rose sharply on the announcement: benchmark ten-year yield near 4 percent, compared to 3.5 percent at the time of Portugal’s exit from the EFF in May 2014.
    - A syndicated 10-year issuance was placed in mid-January at a yield of 4.2 percent.
  - Portugal’s PSPP eligibility depends on maintaining an investment grade rating from DBRS; DBRS affirmed Portugal’s rating on October 21 but cited concern about weak growth outlook and noted rising yields could pose a risk.
- Funding needs and resilience:
  - Annual financing needs remain large, but longer average maturity and smoother redemption profile have increased resilience to a rise in borrowing costs.
  - Public DSA stress test: a sustained interest rate shock of 280 basis points would increase the debt-to-GDP ratio by 3 percentage points relative to the baseline by 2021.
- Staff view on repayment capacity:
  - Adequate under a baseline of gradual reduction in monetary accommodation, but vulnerable to negative surprises (deterioration in macro outlook, external shocks such as US yield curve steepening, rising global yields, hard landing in China, or negative banking system shocks).
  - A negative banking shock could be particularly damaging by triggering a reinforcing cycle of restricted market financing and rising yields.
- Authorities’ views on financing:
  - Authorities confident that recent macro and fiscal developments and steps to shore up the banking system would support continued favorable access to financing.
  - With longer-term yields near 4 percent, authorities acknowledged declining prospective interest savings from further Fund prepayments, and noted negative deposit rates increase cost of retaining a large cash buffer.

### POLICY DISCUSSIONS — FINANCIAL SECTOR (overview)
- Key challenges:
  - High stock of non-performing loans (NPLs), low bank profitability, and high operating costs constrain banks’ ability to lend adequately for new investment.
  - Weak bank lending contributes to weak investment and restrains growth; weaker growth in turn impedes banks’ ability to reduce NPLs and improve profitability, while hampering fiscal consolidation.
- Authorities’ stance and actions:
  - Authorities appear to be moving toward a more comprehensive approach to address high levels of NPLs, but plans to attract new capital into the banking system had yet to be completed at the time of the report.
  - Outlays for banking sector recapitalization continued to weigh on public debt dynamics.
- Fiscal interaction:
  - The revised 2016 fiscal target appears within reach.
  - Prospective public outlays for Caixa Geral de Depósitos (CGD) recapitalization weighed on public debt at end-2016.
- Policy priorities identified:
  - Ambitious efforts needed to improve financial sector resilience, ensure durable fiscal consolidation, and raise potential growth to reduce domestic risks.
  - The interlinkages between modest growth, large annual financing needs, and a challenged banking system leave Portugal vulnerable to shocks that could trigger changes in market sentiment and elevate borrowing costs.

*International Monetary Fund. EXECUTIVE SUMMARY (cr1758).*

### 12.       As discussed in the 2016 Article IV, the Portuguese

### 12.       As discussed in the 2016 Article IV, the Portuguese

### Banking sector: asset quality, provisioning, and capitalization
- Authorities estimated the outstanding stock of NPLs at €49 billion at end-2015 (27 percent of GDP), accounting for both overdue and unlikely-to-pay loans and representing 19 percent of total loans.
- Credit at risk rose to 12.6 percent of gross loans in 2016Q3, up from 12 percent at end-2015.
- Corporate credit at risk was 20.2 percent in 2016Q3; credit at risk on household loans for house purchase was 6 percent.
- Portugal had the second lowest CET1 ratio in the EU at 12.3 percent of risk-weighted assets as of 2016Q3 (based on EBA data).
- Provisioning coverage ratio and credit-at-risk time series shown (last observation Jun. 2016; source: Bank of Portugal).

### Banking sector: capital sufficiency and recent measures
- Total capital above regulatory requirements appears insufficient to tackle the likely capital shortfall if NPLs are fully provisioned for.
- Banks have increased loan loss impairments and reduced operational costs, but low interest margins and weak asset quality continue to drag profitability.
- Individual bank strategies and interventions:
  - Preliminary agreement with the EC on a €5 billion recapitalization of CGD: public sector contribution of €2.7 billion and a new subordinated debt issue of €0.5 billion, plus cost-cutting measures and improved corporate-governance rules. An asset impairment review and market test to determine exact recapitalization need and a market test are expected to be completed in the first quarter of 2017.
  - Negotiations to sell Novo Banco remain ongoing; terms and potential need for additional government support and/or regulatory approval remain to be clarified.
  - Private capital injection in BCP with commitments by largest shareholders to increase holdings by up to 30 percent of total shares has received shareholder and regulatory approvals.
  - BPI’s takeover by CaixaBank has received regulatory approval.

### Staff views on banking-sector strategy
- A comprehensive balance sheet clean-up is essential to break the vicious circle between weak banks, high NPLs, and low growth.
- Elements of the recommended strategy:
  - A predictable, time-bound and credible plan for efforts across banks to write-off or restructure non-performing legacy assets.
  - Strengthen internal governance and improve bank profitability, including further cutting costs.
  - Supervisors should ensure banks set ambitious targets for NPL reduction and incentivize moving NPLs off balance sheets by forcing increased coverage ratios, including setting aside additional provisions for unlikely-to-pay loans that could be reported as non-distributable capital reserves.
  - Banks should adopt a more proactive focus on profitability, underpinned by additional cost reductions and efficiency gains.
- Predictability from a comprehensive strategy is necessary to attract new private capital; the high level of public debt limits fiscal space to finance a ‘bad bank’.

### Authorities’ views on banking-sector measures
- Authorities are considering a more systemic approach to dealing with legacy assets, including supervisory, legal and judicial measures to incentivize banks to dispose non-performing loans.
- Aim to strengthen banks’ balance sheets and reduce high debt levels in the nonfinancial corporate sector, with positive effects on equity, investment, employment, and growth.
- Authorities noted banks have deleveraged and reduced operational costs but need to continue increasing profitability, improve corporate governance, and invest in innovation.
- Authorities emphasized the stock of NPLs is fully accounted for in their latest estimates.
- Banks remain liquid but more cautious in lending; higher underwriting standards have led banks to provide credit mainly to low-risk borrowers, even at lower credit spreads. Credit demand is constrained by high nonfinancial corporate sector debt.

### Fiscal policy: recent performance and outlook
- Revised 2016 fiscal deficit target of 2.5 percent of GDP agreed with the European Commission appears within reach; a further reduction to 1.6 percent of GDP is planned in 2017.
- 2016: sizable revenue shortfall and higher-than-planned spending on public wages likely offset by large under-execution of budgeted intermediate consumption and public investment.
- 2017 budget measures: full removal of the personal income tax surcharge and unfreezing of pension indexation at a total cost of 0.2 percent of GDP; primarily offset by hikes in property taxes and indirect taxes, and projected increases in non-tax revenues and recovery of outstanding tax debt.
- Impact of CGD recapitalization on public debt:
  - Public sector cash contribution under current plan will amount to 1.5 percent of GDP.
  - Conversion of the state’s contingent convertible bonds and transfer of the state’s equity stake in a CGD subsidiary will equal an additional 0.8 percent of GDP.
  - As a result, public debt rose to close to 131 percent of GDP at end-2016, with a modest decline to around 130 percent projected for end-2017.
- Statistical treatment of the CGD transaction remains unclear; pending Eurostat ruling, the operation is included as a non-deficit increasing financial transaction in staff’s projections for 2017, with an impact on public debt but not the fiscal deficit.

### Staff views on fiscal policy
- The 2017 budget depends largely on optimistic revenue projections, raising risks to execution.
- Spending containment appears based primarily on untargeted measures and mid-year adjustments rather than durable reforms to improve efficiency.
- The planned deficit reduction relies heavily on one-off revenues: repayment of a state guarantee called in 2010 (0.2 percent of GDP) and an increase in dividend payments from the central bank (0.2 percent of GDP).
- On the basis of approved measures, staff projects a fiscal deficit of 2.1 percent of GDP for 2017, an implied structural primary loosening of 0.1 percent of GDP (compared with the Article IV recommendation of a tightening of 0.6 percent).
- Compression of capital spending could harm output; public investment was significantly lower than the EU average over the last five years and is likely to fall further, exacerbating the long-term decline in private investment.
- Increase in arrears in January-November 2016, particularly in hospitals, adversely impacts private providers and is likely to increase spending pressures in 2017.
- While a shift from direct to indirect taxation could support growth in principle, frequent tax regime changes risk adverse effects on investment.

### Authorities’ views on fiscal policy
- Authorities were confident 2016-17 targets would be met, supported by additional revenue from recovery of outstanding tax debt.
- Emphasized success in controlling spending in 2016 by freezing part of line ministries’ budget allocations and planned continuation in 2017, supported by savings from the ongoing spending review.
- Highlighted positive response to the tax recovery scheme announced in late 2016 and confidence that additional revenues would offset spending pressures and help reduce health-sector arrears.
- Raised concerns that staff estimates of potential growth used to calculate the structural adjustment understated fiscal consolidation efforts in 2016-17.

### Structural reforms: progress and priorities
- Implementation of macro-critical reforms has largely stalled over the past year, worsening the drag on potential growth from low investment and a shrinking labor force.
- IMF staff 2015 survey and World Economic Forum 2016-17 GCR highlight structural gaps: effectiveness of public administration and judicial system, payments discipline of public sector entities, insolvency and corporate debt restructuring frameworks, labor market flexibility.
- Authorities’ National Reform Program 2016-2020 key components:
  - Development of human capital: better formal education, lifelong learning, improvements in managerial skills.
  - Recapitalization of the corporate sector: develop instruments to diversify financing sources, incentivize equity and reduce reliance on bank financing.
  - Modernization of the public sector: simplify administrative and licensing procedures for enterprises.
  - Encourage R&D, innovation and entrepreneurship.
- Minimum wage policy: authorities approved a further 5 percent increase in the minimum wage from 2017, above labor productivity growth; following increases of 4 percent in October 2014 and 5 percent in January 2016, implying a cumulative real increase of around 13 percent since mid-2014.

### Staff views on structural reforms
- Reinvigoration of the structural reform agenda is essential to improve growth prospects and support fiscal consolidation.
- Staff advises emphasis on reforms closely aligned with macro-critical structural gaps affecting labor market and export competitiveness.
- Recommendations:
  - Link minimum wage increases to productivity to maintain competitiveness, given the ratio of minimum to median wages in Portugal remains well above the euro area average.
  - Bridge the gap between temporary and permanent contracts; the gradualist approach has left flexibility largely borne by newer entrants on temporary contracts.
  - Ensure an appropriately inclusive social dialogue engaging unemployed, broader labor force, and a wide cross-section of employers.

### Staff appraisal: macro outlook and priorities
- Portugal experienced a welcome pick-up in activity in 2016Q3 after a subdued first half of 2016; growth projections for 2016-17 have been upgraded slightly and near-term risks are broadly balanced.
- Medium-term growth outlook remains constrained by high debt and structural bottlenecks; consumption-based recovery is likely to run out of steam due to depleted household savings and poor bank asset quality limiting financing for new investment.
- Public debt dynamics remain fragile and vulnerable to changes in financing conditions; Portugal faces interlinkages between a modest macro outlook, large annual financing needs, and a struggling banking system that could trigger sudden shifts in sentiment.
- Key priorities to reduce vulnerabilities:
  - Aggressively address NPLs and attract new bank capital.
  - Advance fiscal consolidation based on durable expenditure reform.
  - Reinvigorate the structural reform agenda.
- Portugal has maintained market access at relatively low but rising yields in 2016; financing environment may become less benign as euro-area monetary normalization is priced in.
- Under the baseline of gradual reduction in monetary accommodation, the Fund considers Portugal’s capacity to repay adequate, but there are tangible risks of faster upward pressure on borrowing costs if negative surprises materialize.

*International Monetary Fund staff summary of chapter 12 from the country report.*

### 33.      Greater efforts to push forward with structural reforms are needed to boost the

### 33.      Greater efforts to push forward with structural reforms are needed to boost the economy’s growth potential.

### Structural reforms and growth potential
- As a member of a currency union with limited fiscal space, it is essential that labor markets have sufficient flexibility for adjustment.
- Full implementation of the already-enacted reforms in labor and product markets must be complemented by additional steps to promote growth and competitiveness, with a particular focus on streamlining the functioning of the public sector.

### Labor market dynamics and minimum wage
- A further increase in the minimum wage risks undermining labor competitiveness.
- Labor market adjustment continues to be largely borne by newer entrants to the labor force on temporary contracts.

### Selected macroeconomic projections and key statistics (from Tables 1–4)
- Real GDP growth projections: 2017: 1.3; 2018: 1.3; 2019: 1.2; 2020: 1.2; 2021: 1.1.
- Unemployment rate (Percent): 2016: 11.8; 2017: 11.0; 2018: 10.6; 2019: 10.1; 2020: 9.7; 2021: 9.2; 2022: 8.8 (Table 1 shows through 2021).
- General government balance (Percent of GDP): 2016: -3.0; 2017: -2.6; 2018: -2.1; 2019: -2.3; 2020: -2.2; 2021: -2.2.
- General government debt (Percent of GDP): 2016: 128.3; 2017: 130.8; 2018: 129.8; 2019: 128.7; 2020: 127.2; 2021: 126.2; 2022: 125.3 (Table 1).
- Current account balance (Percent of GDP; 12-month rolling sum): Last obs. Sep. 2016 shown in Figure 4; Table 4 (Billions of euros) shows Current account: 2016: 0.5; 2017: -1.1; 2018: -1.3; 2019: -1.8; 2020: -2.3; 2021: -2.9.
- Trade balance (Goods, Percent of GDP): 2016: -5.3; 2017: -5.1; 2018: -5.9; 2019: -6.3; 2020: -6.8; 2021: -7.3; 2022: -7.7 (Table 1).
- Gross national savings (Percent of GDP): 2016: 15.9; 2017: 15.5; 2018: 15.4; 2019: 15.6; 2020: 15.9; 2021: 16.2; 2022: 16.6 (Table 1).
- Gross fixed investment (Year-on-year percent change): 2016: -5.1; 2017: 2.3; 2018: 4.5; 2019: -1.2; 2020: -1.1; 2021: 2.8; 2022: 2.4 (Table 1).
- Private sector credit (Year-on-year percent change): 2016: -2.2; 2017: -2.2; 2018: -0.5; 2019: 0.1; 2020: 0.8; 2021: 1.6; 2022: 1.6 (Table 1).

### Fiscal and financing pressures (Tables 2a, 8)
- General government revenue (Billions of euros): 2016: 79.8; 2017: 82.8; 2018: 84.1; 2019: 85.9; 2020: 87.8; 2021: 89.8.
- Expenditure (Billions of euros): 2016: 84.6; 2017: 86.8; 2018: 88.5; 2019: 90.4; 2020: 92.4; 2021: 94.7.
- Net lending (+)/borrowing (–) (Billions of euros): 2016: -4.7; 2017: -3.9; 2018: -4.4; 2019: -4.4; 2020: -4.6; 2021: -4.8 (Table 2a).
- Gross borrowing need (Billions of euros): 2017: 26.4; 2018: 25.6; 2019: 33.8; 2020: 34.3; 2021: 39.7 (Table 8).
- Market access assumed to cover the bulk of gross financing sources: Market access (Billions of euros) total equals gross financing sources each projection year (Table 8).

### Financial sector and external resilience (Figures 3–4; Tables 3, 6, 9)
- Eurosystem financing (Billions of euros): Last obs. Sep. 2016 shown in Figure 3.
- Credit at risk (Percent of total loans) and provisioning coverage ratio (Percent) — Last obs. Jun. 2016 (Figure 3).
- Baseline external debt (Percent of GDP) and projections (Table 6): 2013: 226.9; 2014: 235.5; 2015: 221.8; 2016: 213.9; 2017: 208.3; 2018: 204.6; 2019: 199.8; 2020: 195.5; 2021: 191.6.
- Gross external financing need (Billions of Euros): 2017: 188.5; 2018: 188.7; 2019: 161.1; 2020: 170.2; 2021: 165.8; 2022: 163.9; 2023: 168.6; 2024: 172.5; 2025: 176.9 (Table 6 shows series through projection years labeled).
- External debt-to-exports ratio (Percent): 2013: 563.1; 2014: 575.6; 2015: 534.5; 2016: 526.2; 2017: 482.2; 2018: 458.9; 2019: 436.0; 2020: 415.4; 2021: 399.4.

### Policy recommendations and priorities
- Fully implement enacted labor and product market reforms to increase labor market flexibility and adjustment capacity within the currency union context.
- Complement existing reforms with additional measures to promote growth and competitiveness, prioritizing the streamlining of public sector functioning.
- Avoid further increases in the minimum wage that could undermine labor competitiveness while labor adjustment is concentrated among newer entrants on temporary contracts.
- Strengthen measures to reduce external and fiscal vulnerabilities given projected gradual declines in external debt ratios and persistent financing needs highlighted in gross borrowing and external financing requirement tables.

*Source: cr1758 - 33. Greater efforts to push forward with structural reforms are needed to boost the economy’s growth potential (IMF staff paper excerpts and associated tables and figures).*

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

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

### A. Baseline Scenario
- Staff’s Public DSA framework for Market-Access Countries indicates Portugal’s gross debt trajectory is subject to significant risks given a sizable debt burden and gross financing needs.
- Key baseline projections and assumptions:
  - Fiscal deficit projection for 2016: 2.6 percent of GDP (revised down from 3 percent).
  - Public contribution to recapitalization of CGD: 1.5 percent of GDP.
  - Public gross debt projected to rise from 129.1 to 130.8 percent of GDP at end-2016 (slightly above previous peak of 130.6 percent in 2014).
  - Public debt net of central government deposits projected to decline slightly from 121.6 percent to 121.3 percent of GDP in 2016.
  - Headline fiscal deficit stabilizes at around 2 ¼ percent of GDP through the medium term (2018–21), with public debt modestly declining to 124.9 percent of GDP in 2021.
  - Deposits are expected to decline in 2017 to fund the recapitalization of CGD; further drawdown of cash deposits from 2018–21 projected to be modest to maintain cover for 6 months’ refinancing needs.
  - Potential proceeds from sale of financial sector assets (including Novo Banco) are not included in the baseline.

### B. Risk Assessment
- Portugal’s debt and financing profile:
  - Debt ratio under the baseline already exceeds the debt burden benchmark for advanced economies of 85 percent of GDP.
  - Public gross financing needs fall slightly below the relevant benchmark of 20 percent of GDP during the projection period.
  - Improvements in redemption profile and near-term refinancing needs attributed to longer-term issuance and shorter-term debt buybacks.
- Profile vulnerability assessments:
  - Debt profile subject to medium to low risks for market perception, projected change in short-term debt, and share held by nonresidents.
  - Standardized contingent liabilities shock from the MAC DSA template does not apply because bank vulnerabilities are below thresholds; replaced by a customized shock addressing contingent liabilities from SOEs and PPPs.
- Note on external financing requirements:
  - Total (public and private) external financing requirements exceed the relevant benchmark under the baseline; in Portugal this figure includes non-residents bank deposits accounting for about 45 percent of GDP.

### C. Realism of Baseline Assumptions and Alternative Scenarios
- Growth and realism:
  - Staff’s updated projection assumes a potential growth rate with medium-term average annual real GDP growth of 1.2 percent.
  - Authorities’ Stability Program assumes annual real GDP growth of 2.0 percent in 2017–20 (versus staff’s 1.2 percent average for same period).
  - Portugal’s growth forecast track record shows a relatively large median error compared with other countries with Fund-supported programs.
  - If growth underperforms (e.g., reversal of structural reforms), the rate of debt decline would significantly slow.
- Primary balance and fiscal strategy:
  - Under staff’s baseline, the fiscal primary balance is expected to stabilize at around 2 percent of GDP over the medium term.
  - The primary balance is expected to exceed its debt-stabilizing threshold over the projection period.
  - Authorities’ Stability Program projects public debt reduction to 110.3 percent of GDP by 2020, based on an ambitious timetable and optimistic assumptions about receipts from sale of financial sector assets and medium-term growth.

### D. Stress Test (Implications and Quantified Scenarios)
- Summary of stress-test outcomes (2016–2021):
  - Growth shock:
    - A shock that lowers output by nearly 4.5 percentage points in 2016–17 (and inflation by cumulative 1 percentage point) would lead debt to peak at about 139 percent of GDP in 2018, which is 9 percentage points higher than the 2016 baseline.
  - Deflation scenario:
    - A sharper growth shock lowering output by 5½ percentage points in 2016–17 and inflation lower by cumulative 4 percentage points would push debt to 148 percent of GDP by 2018 and keep it close to that level over the medium term.
  - Sustained interest rate shock:
    - A sustained interest rate shock of 280 basis points throughout the projection period would have limited immediate effect but by 2021 the debt-to-GDP ratio would be about 3 points higher compared with the baseline.
  - Customized contingent liabilities shock:
    - Under a severe scenario, further contingent liabilities could potentially materialize of about 10 percent of GDP (due to financial sector risks, SOEs, PPPs, and State guarantees).
    - A contingent liabilities shock of this magnitude would push the 2017 debt ratio to 140 percent of GDP.
  - Severe combined shock:
    - A severe combined shock incorporating the above macro-fiscal and contingent liabilities adverse scenarios would raise debt to 148 percent of GDP in 2018 and keep it at that level over the medium term.
- Staff’s assumptions for the adverse contingent liabilities scenario include:
  - (i) hypothetical cost of further financial sector operations;
  - (ii) staff’s estimate of potential contingent liabilities from PPPs based on financial rebalancing requests by concessionaires;
  - (iii) hypothetical settlement of the outstanding stock of arrears;
  - (iv) staff’s estimate of potential contingent liabilities from other non-bank debt directly guaranteed by the State and/or classified outside the general government perimeter.

### E. Authorities’ Views and Policy Implications
- Authorities’ stance:
  - Authorities noted the risks highlighted by staff but were more optimistic about medium-term outlook.
  - They argued reforms have laid foundation for stronger export-oriented growth and expected stronger improvement in medium-term debt dynamics than staff’s baseline.
  - Authorities were confident the 2017 fiscal deficit target would be achieved, leading to a larger reduction of the debt-to-GDP ratio by end-2017.
  - They reiterated commitment to medium-term fiscal consolidation as outlined in the 2016 Stability Program and the 2017 Budget.
- Staff policy message:
  - Additional fiscal consolidation remains critical to anchor debt on a downward-sloping path, boost policy credibility, and strengthen resilience to reversals in market sentiment.
  - Debt dynamics remain vulnerable to adverse yet plausible macro-fiscal and contingent liabilities shocks, including possible need for further fiscal support for the financial sector.
  - The risk of a contingent liabilities shock materializing remains elevated given financial sector vulnerabilities.

*Source: IMF staff analysis, Annex I. Public Debt Sustainability Analysis (DSA).*

### Annex II. Risk Assessment Matrix

### Annex II. Risk Assessment Matrix

### Risk assessment framework
- The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).
- Relative likelihood classification: "low" indicates a probability below 10 percent, "medium" a probability between 10 and 30 percent, and "high" a probability between 30 and 50 percent.
- "Short term" and "medium term" indicate the risk could materialize within 1 year and 3 years, respectively.
- Non-mutually exclusive risks may interact and materialize jointly.

### Major risks, impacts, and policy responses
- Loss of investor confidence due to reform reversals or other negative surprises (including difficulties in the banking sector or loss of sole investment-grade rating)
  - Relative Likelihood: High
  - Impact: High
    - Increase in sovereign bonds yields and reduction in foreign direct investment.
    - Tighter ECB policies, including a reduction in asset purchases.
    - Significant funding distress and higher public and private borrowing costs.
  - To minimize exposure: Strengthen policy buffers and avoid backtracking on reforms.
  - If risk materializes: Take steps to restore market access at favorable terms and ensure banks’ access to liquidity is maintained. Take fiscal measures to ensure fiscal targets are being met.

- Financial distress in one or more banks, requiring intervention
  - Relative Likelihood: Medium
  - Impact: High
    - Loss of confidence in the banking system, resulting in potentially high fiscal costs.
  - To minimize exposure: 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.
  - If risk materializes: Shore up the banks using the existing toolkit, while ensuring public debt dynamics are not compromised.

- Economic fallout from political fragmentation (including post-Brexit negotiation uncertainty)
  - Relative Likelihood: Medium
  - Impact: Medium
    - Portugal exports 3 percent of its GDP to the UK.
    - UK tourists account for more than 17 percent of tourist receipts from foreigners in 2015.
  - If risk materializes: UK and EA institutions should work collaboratively towards a smooth and predictable transition. ECB policy actions to rein in financial volatility risk. Renewed structural reform effort to expand exports to other markets.

- Tighter and more volatile global financial conditions
  - Relative Likelihood: Medium
  - Impact: High
    - Sharp rise in risk premia with flight to safety, poor market liquidity, safe-haven currency surges (especially the US dollar) creating balance sheet strains for FX debtors.
    - Given its high corporate and private debt levels, Portugal would be highly susceptible to financial contagion; heightened financial stress in the Portuguese banking system.
  - To minimize exposure: Shore up liquidity and capital buffers; encourage private savings, and shrink private sector balance sheets.
  - If risk materializes: ECB policy actions to ensure market liquidity, encourage lending to productive investment opportunities, and ensure orderly monetary transmission mechanisms, including expansion of asset purchase programs.

- Weaker-than-expected global growth
  - Relative Likelihood: High for US, euro area, and Japan; Medium for Emerging Markets
  - Impact: High
    - Low growth would imperil debt dynamics in all sectors; the euro area accounts for 60 percent of total exports.
  - To minimize exposure: Step up structural reforms to improve competitiveness and reduce debt overhang.
  - If risk materializes: Accelerate and deepen domestic structural reforms.

- Persistently lower energy prices (supply factors)
  - Relative Likelihood: High
  - Impact: Medium
    - A low fuel import bill may be offset by greater difficulties in Angola, a key economic and financial partner.
  - To minimize exposure: Step up efforts to clean up corporate balance sheets, including the reduction of exposures to Angola.
  - If risk materializes: 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.

### Policy priority synthesis from RAM
- Strengthen policy and fiscal buffers to reduce vulnerability to funding shocks.
- Maintain continuity of reforms to preserve investor confidence and market access.
- Proactive bank supervision, capital and liquidity buffers, and targeted tools to address NPLs.
- Coordination with ECB and international partners to manage spillovers from global financial volatility and Brexit-related uncertainties.
- Accelerate structural reforms to improve competitiveness and reduce debt overhang.

### Explanatory note
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities.

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### Overview and authorities' assessment (Statement by Mr. Carlo Cottarelli and Ms. Ines Lopes, February 17, 2017)

### I. Overview — authorities’ priorities and assessment
- The Government reiterates commitment to economic and fiscal policies that promote sustained and inclusive growth within fiscal consolidation.
- Policy focuses:
  - Recovery of households’ and firms’ incomes by reducing fiscal burden and improving labor market conditions.
  - Capitalization of firms to allow investment, job creation, and growth.
  - Address remaining challenges of the financial system to support investment recovery.
- The Government considers that progress in economic, fiscal, financial and structural fronts in 2016 is not fully recognized in the staff report.

### Key 2016 achievements cited by authorities
- GDP increased by 1.4 percent according to INE.
- Public deficit expected to be clearly below 2.3 percent of GDP.
- Primary surplus expected to be above 2 percent.
- Employment growth, unemployment close to single digits.
- 2017 State Budget approved in November will continue the consolidation and reform path.

---

### Recent developments and outlook

### II. Recent macroeconomic developments
- Q3 and Q4 2016: Portugal registered one of the highest GDP growth rates in the euro area.
- Balance of goods and services: increase of €938 million up to November 2016 vs. same period in 2015.
- Unemployment rate: 10.5 percent in Q4 2016, 1.7 percentage points below Q4 2015.
- Investment indicators:
  - Private entrepreneurial investment rose 7.7 percent in Q3 2016.
  - Imports of equipment goods increased 8.5 percent in Q3 2016.
  - Heavy and light commercial vehicles sales expanded 12 percent in the second semester of 2016.
- Consumer confidence indicators at a 17 year high.
- Government 2017 expectations:
  - GDP growth to accelerate to 1.5 percent.
  - Investment to increase by 3.1 percent.
  - Labor productivity to improve by 0.5 percent.
  - Unemployment to improve over the 10.3% target envisaged in the 2017 State Budget.
- EC Winter Forecast revised Portugal’s growth projection for 2017 to 1.6 percent, up from 1.2 percent in the Autumn Forecast.

---

### Financial sector assessment

### III. Banking system developments and challenges
- Structural adjustment since 2010 affected balance sheets, solvency and cost structures.
- Ongoing challenges:
  - Subdued profitability due to NPLs, cost cutting, low interest rates, weak growth, and uncertainty about international activity contribution.
  - Flow of impairments weighing on profitability.
- Positive developments:
  - Loan-to-deposit ratio reduced from a peak of 165 percent to 102 percent in June 2016.
  - Continued decline in reliance on Eurosystem financing in 2016.
  - Net interest income recovery (due to lower deposit interest rates); income from financial operations declined.
  - Reduction in administrative costs continued from 2015 restructuring efforts, though cost-to-income ratio increased year-on-year due to lower operating profits.
  - Capital ratios fell marginally in H1 2016 owing to weak profitability and elimination of transitional provisions under CRDIV/CRR; CET 1 ratio lower than European peers at end-Q1 2016, but leverage ratio compares well.
- NPLs and non-productive assets:
  - Persistently high levels of NPLs, especially among non-financial corporations, hamper profitability and market perceptions of resilience.
  - Systemic nature and European dimension merit a comprehensive and coordinated European approach.
  - National measures required: intrusive banking supervision; reforms in legal/judicial/tax frameworks; promotion of portfolio-oriented NPL management (subject to EU regulatory context, including State Aid and BRRD).

### Corporate and household financing trends
- Financing of companies with better risk profiles continues.
- Share of construction sector in loan book reduced; manufacturing and trade shares increased.
- Loans by resident financial sector to non-financial corporations continued to decline; total corporate debt slightly increased due to non-resident lending.
- Credit to exporting companies growing at more favorable rates than the average.
- Household mortgage credit continued deleveraging since 2011; consumer and other credit accelerated positive growth since H2 2015.
- Banco de Portugal monitoring these developments as national macroprudential authority.

### Authorities’ actions in 2016 to strengthen banks
- Legislative and policy measures to strengthen capital and facilitate NPL recovery:
  - Stabilized shareholders’ structures and capital raising by main private banks.
  - Re-launched selling process of Novo Banco with reinforced capital ratios and bidder interest.
  - Stabilized stock of DTAs and clarified procedural aspects.
  - Extended maturity and reduced interest payments of the loan to the Resolution Fund.
  - Ongoing capitalization of Caixa Geral de Depósitos (CGD) following EC approval of the business plan recognizing non-state aid nature of the investment.

---

### Fiscal policy

### IV. Fiscal outcomes and 2017 budget
- 2016 fiscal results:
  - Deficit expected to be clearly below 2.3 percent of GDP.
  - Primary surplus expected to be above 2.0 percent of GDP.
  - According to EC Winter Forecast, Portuguese primary government surplus in 2016 is foreseen to have been the third largest in the euro area.
- 2017 State Budget (approved November 29) strategy pillars:
  - (i) strict control of public expenditure with continued spending review (health, education, public procurement, including SOEs);
  - (ii) promotion of investment via incentives for firm capitalization and job creation;
  - (iii) fiscal stability and fight against fraud and tax evasion;
  - (iv) public administration reform;
  - (v) support for National Reforms Program measures.
- 2017 fiscal projections by Government:
  - Public deficit decreasing to 1.6 percent of GDP.
  - Primary surplus increasing to 2.8 percent of GDP.
  - Public investment forecast to reach 2.2 percent of GDP in 2017.
- Public debt dynamics:
  - 2016 general government debt-to-GDP ratio close to 130 percent, mainly due to prefunding financing needs for CGD recapitalization that will occur in 2017 (€2.7 billion).
  - Central administration deposits (cash-buffer) amounted to €10.2 billion at end-2016 (€6.6 billion in 2015).
  - After stabilization, debt-to-GDP ratio expected to decrease in 2017 due to primary surplus and accelerating growth.

---

### Structural reforms

### V. National Reforms Program and implementation
- National Reforms Program (NRP) published end-March 2016 with ambitious agenda and calendar; based on EC Country Specific Recommendations.
- NRP objectives: address
  - (a) historical skills deficit;
  - (b) medium-low innovative character of the economy;
  - (c) modernization of public sector, administrative and licensing simplification, reduction of red tape costs;
  - (d) high levels of public and private debt constraining investment;
  - (e) ensuring social cohesion and equality for sustainable growth.
- National Skills Strategy to be supported by the OECD.
- Implementation monitoring: states of play published every six months (first assessment September 2016).
  - Of 139 measures proposed, 2/3 were concluded or put in place in 2016; for the remaining 1/3, 78% were launched or are ongoing.
- Early indicators and outcomes:
  - Improvements in structural indexes reported by World Bank, World Economic Forum, and OECD.
  - OECD’s PISA results: Portugal registered one of the largest improvements and is now above the OECD average in all indicators.
  - Expected outcomes: higher confidence, strengthened export capacity, recovery in investment, continued decline in unemployment and youth unemployment.

---

### Conclusion

### VI. Authorities’ concluding views
- Authorities are confident obligations towards the Fund will continue to be timely met.
- Continued commitment to a strategy promoting sustained and inclusive growth within growth-friendly fiscal consolidation.
- Positive 2016 fiscal and economic results support continued efforts in 2017.
- 2017 State Budget and National Reforms Program expected to decisively contribute to consolidate the recovery.
- Authorities look forward to the sixth PPM mission to deepen dialogue with the Fund.

*Source: Annex II. Risk Assessment Matrix and Statement by Mr. Carlo Cottarelli and Ms. Ines Lopes, Portugal, February 17, 2017.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr1758.pdf_