EUROPEAN COMMISSION Brussels, 22.2.2017 SWD(2017) 87 final COMMISSION STAFF WORKING DOCUMENT Country Report Portugal 2017

Including an In-Depth Review on the prevention and correction of macroeconomic

imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2017 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews

under Regulation (EU) No 1176/2011



{COM(2017) 90 final}

{SWD(2017) 67 final to SWD(2017) 93 final}



Contents Executive summary1 1.Economic situation and outlook4 2.Progress with country-specific recommendations11 3.Summary of the main findings from the MIP in-depth review15 4.Reform priorities21 4.1.Public finances and taxation271 4.2.Financial sector and indebtedness27 4.3.Labour market, education and social policies33 4.4.Investment40 4.5.Sectoral policies46 4.6.Public administration51 A.Overview table55 B.MIP Scoreboard63 C.Standard tables64 References69 LIST OF Tables 1.1.Key economic, financial and social indicators - Portugal10 2.1.Summary table on 2016 CSR assessment13

3.1.MIP assessment matrix - Portugal 201719 B.1.The MIP Scoreboard for Portugal63 C.1.Financial market indicators64 C.2.Labour market and social indicators65 C.3.Expenditure on social protection benefits (% of GDP)66 C.4.Product market performance and policy indicators67 C.5.Green growth68 LIST OF Graphs 1.1.Real GDP growth and its components4 1.2.Activity, employment and unemployment rates (quarterly)5 1.3.Employment by type (permanent, temporary, selfemployed), yearonyear changes5 1.4.Inequality of income distribution (S80/S20 income quintile share ratio)6 1.5.NIIP and Current Account evolution6 1.6.Revealed Comparative Advantage Index (goods)7 1.7.Nominal ULC, index 2001Q1=1007 1.8.Wage growth consistent with constant external competitiveness and actual wage growth8 1.9.Productivity decomposition in the overall economy8 1.10.Potential growth and its components9 3.1.Banking sector situation and domestic debt levels16 4.1.1.Combined interest rate and GDP growth shock (chart to be updated)21

4.1.2.Fiscal consolidation22 4.2.1.Debt breakdown by sector in 2002201630 4.2.2.Breakdown of yearonyear changes in debttoGDP ratios, NFCs30 4.2.3.Breakdown of yearonyear changes in debttoGDP ratios, households31 4.2.4.Breakdown of Portugal's Net International Investment Position (NIIP) 31 4.2.5.Current account financing32 4.2.6.NIIP sensitivity to macroeconomic shocks32 4.3.1.Unemployment by duration33 4.3.2.Main social indicators35 4.4.1.Investment productivity40 4.4.2.Investment and its components40 4.4.3.Private and public investments41 4.4.4.Most problematic factors for doing business42 4.4.5.World Economic Forum's 20162017 Global Competitiveness Report, Portugal42 4.4.6.Foreign direct investment42 4.4.7.Component contributions to change in CA balance 2007201543 4.4.8.Nominal unit wage costs by sector44 4.4.9.Average Quality Rank in the 5 biggest exporting manufacturing sectors44 4.4.10.Dynamism and Competitiveness of Exports (goods) on top10 sector destinations (20132015)44 4.5.1.Restrictiveness indicator, 2016, Portugal and the EU48

4.5.2.Shares for selected countries of total EU maritime transport of goods, 201450 4.5.3.Wageadjusted labour productivity of the ports sector50 LIST OF Boxes 2.1.Contribution of the EU budget to structural change in Portugal14 4.4.1.Investment Box445 4.6.1.Selected highlights54 Executive summary This report assesses Portugal's economy in the light of the Commission's Annual Growth Survey published on 16 November 2016. In the survey the Commission calls on EU Member States to redouble their efforts on the three elements of the virtuous triangle of economic policy – boosting investment, pursuing structural reforms and ensuring responsible fiscal policies. In so doing, Member States should put the focus on enhancing social fairness in order to deliver more inclusive growth. At the same time, the Commission published the Alert Mechanism Report (AMR) that initiated the sixth round of the macroeconomic imbalance procedure. The indepth review, which the 2017 AMR concluded should be undertaken for the Portuguese economy, is presented in this report. While the Portuguese economy has continued to recover for the fourth consecutive year, it remains vulnerable to shocks. Growth in domestic demand is still fuelled by strong private consumption. The conditions for investment remain challenging and continue to drag on growth. However, investment is expected to recover in the mediumterm with the support from EU funds. This will help rebalance the economy by increasing the share of the tradable sectors. Recently, there has been a large increase in the contribution made by net external trade, possibly driven by temporary causes. A steady increase in the terms of trade has helped improve the trade balance of goods. Yet, unit labour costs have risen recently putting pressure on competitiveness. Improvements in terms of trade are expected to fade out while robust domestic demand will contribute to boosting imports and weakening the trade balance. Price pressures are expected to reemerge again, mainly owing to higher oil prices. Employment is set to improve further, albeit more slowly, becoming more aligned with GDP growth. Taken together, real GDP is forecast to have decelerated slightly in 2016 before picking up again in 2017 and 2018. Uncertainty about investment, the banking sector and the implementation of structural reforms pose some downside risks to the sustainable recovery. Public finances are expected to improve, while the fiscal outlook remains subject to downside risks. The headline deficit is projected to decrease further to 2.0 % of GDP in 2017, mainly as a result of the moderate economic recovery and good financing conditions. However, uncertainty about the macroeconomic outlook, the potential impact on the deficit of banking support measures and possible spending slippages pose risks. Following a steep increase during the economic crisis, public debt has stabilised at around 130.0 % of GDP since 2013. Supported by the projected continuing moderate economic recovery and primary surpluses, the debttoGDP ratio is expected to fall gradually from 2017 onwards. The stock of public debt, which is still large, coupled with still relatively high deficit levels and low growth, makes Portugal nevertheless vulnerable to changing economic conditions and rising financing costs. Overall Portugal has made limited progress on addressing the 2016 countryspecific recommendations. There has been some progress in conducting an expenditure review. Expenditure is now subject to more controls and expenditure containment with the launch of spending reviews in some sectors. Some progress has also been made in ensuring the longterm sustainability of the healthcare sector. There has been limited progress towards reducing the reliance of the pension system on budgetary transfers. No progress has been made to restructure the stateowned enterprises sustainability, especially those in the transport sector. In the labour market, limited progress has been made towards keeping minimum wage developments at a level which promotes employment and competitiveness although employment risks have so far not materialised. There has also been limited progress in ensuring the effective activation of longterm unemployed, improving the coordination between employment and social services. Yet, some progress has been made in strengthening incentives for firms to hire through permanent contracts. In the financial sector, limited progress has been made in tackling the high level of nonperforming loans and improving the access to finance for startups and small and mediumsized enterprises via the capital market. Some progress has been made in the debt bias in corporate taxation. There has been some progress in increasing transparency in public procurement, accelerating tax litigations, and incentivising cooperation between universities and businesses. Limited progress has been made in accelerating licensing procedures as well as in reducing regulatory barriers especially in business services. Regarding progress in reaching the national targets under the Europe 2020 strategy, Portugal is performing well in reducing greenhouse gas emissions, the renewable energy target and energy efficiency, as well as reducing early school leaving. There are still considerable obstacles in attaining the targets on employment rate, R&D investment, tertiary education attainment and poverty reduction. The main findings of the indepth review contained in this report and the related policy challenges are as follows: Potential growth still lags behind its precrisis level and is below EU average. It is affected by persistent bottlenecks and rigidities in product and labour markets as well as major external imbalances. Efforts to reduce debt and the stock of banks' nonperforming loans have been limited, holding back more sustained credit recovery and investment. At the same time, public debt sustainability and the reduction of interest rate costs hinge on fiscal discipline and the necessary fiscal adjustment. The external rebalancing of the Portuguese economy is underway, but at a moderate pace. The current account rebalancing, influenced by stronger export performance, is still having a limited impact on the large stock of net external liabilities. High external debt and the vulnerability in the external sector at large are linked to weak productivity and competitiveness, including limited specialisation in sectors with higher value added. The private business sector in Portugal is overindebted. This is closely related to the ongoing adjustment of the Portuguese banking sector. The authorities are taking some policy measures to tackle the high level of nonperforming loans especially in the corporate sector, facilitate business restructuring simplifying administrative processes, improving the insolvency framework and adjusting taxation requirements. The large stock of corporate nonperforming loans continues to pose challenges for the banking sector. Besides the high level of nonperforming loans, Portuguese lenders' vulnerabilities stem from different sources: thin capital buffers, large amounts of foreclosed real estate assets, elevated exposures to the Portuguese sovereign debt, as well as weak business models and profit rates of Portuguese banks. Although some measures have been taken to reduce incentives to debt financing, corporate taxation still shows a relatively high debt bias.

Ensuring public debt sustainability in the medium and long term hinges on a solid budgetary consolidation. It also relies on growth enhancing structural measures as well as expenditure containment and growthfriendly optimisation of revenue flows e.g. regarding the efficiency of indirect taxation. While reforms in the pension system have reduced its longterm costs, it still relies on extraordinary budgetary transfers over the medium term. In the healthcare sector, measures to promote prevention and primary care have been put forward and could probably help cut costs in the long term. However, the growing stock of arrears in hospitals and recent measures concerning public sector working hours weigh on the capacity to improve healthcare infrastructure and services. Indebtedness of stateowned enterprises remains high, mainly in the transport sector. A plan to improve monitoring is being set up, but there are no concrete measures to ensure cost efficiency, and sound debt management. The negative operational performance and delay in setting up a governance framework for metropolitan transport further exacerbate the risks of a debt increase. Finally, the current spending review would benefit from a more comprehensive and strategic approach. Unemployment keeps falling and employment growing, while longterm and youth unemployment still remain high. Half of the unemployed have been jobless for a year or more, while a quarter of young workers are unemployed. Longterm unemployment can make it harder to return to work harming Portugal’s growth potential. Other key economic issues which point to particular challenges facing Portugal's economy are as follows: The rising minimum wage may help reduce inwork poverty, but it poses some employment risks. Between 2015 and 2017 the minimum wage rose faster than prices and average productivity. This can reduce inwork poverty and impact aggregate demand positively. At the same time, it is becoming increasingly binding, covering a fifth of all workers by 2016. Employment risks seem less pressing in the current context of job recovery, but remain a challenge, especially as regards young and lowskilled workers. While incentives for firms to hire through permanent contracts were strengthened, the labour market remains segmented. Although financial incentives for permanent hiring have been adopted, some aspects of labour law may still discourage employers from hiring permanent workers. This has potentially negative social consequences and hampers productivity growth. Extensive use of temporary contracts may increase labour market turnover. Younger people are more likely to be on such contracts and are thus more vulnerable to unemployment spells. As they have higher levels of formal skills, this may harm potential growth. The proportion of people at risk of poverty or social exclusion fell in 2015. This is in line with labour market improvements, but the overall level remains high. Income inequality also declined. Inwork poverty remained one of the highest in the EU in 2015, partly due to low quality jobs and a high involuntary parttime employment. It is still not reflecting the recent recovery in the labour market. Measures in the area of social assistance were taken in 2016 to improve income conditions of people in low income households School outcomes are improving but the skill level of the labour force, including digital, remains low. Tertiary attainment has stagnated below EU average and higher education offer is scattered. In spite of efforts made, obstacles to more structured university business cooperation and knowledge transfer remain, hampering innovation and the transition to a knowledge based economy. Regulatory and administrative barriers, restricting investment and efficient resource allocation, have been tackled partially. The government has put forward measures to ease businesses' financing needs. Yet, access to finance remains a concern for small and mediumsized business. The authorities are putting forward a framework for assessing the regulatory burden of new legislation on entrepreneurs. At the same time, there still are weaknesses in the areas of the judicial system, the energy sector, transport, the business environment and the innovation framework. There are also barriers to the access to certain regulated professions and to more simplified authorisation procedures. Previous reforms targeting the most restrictive business services, including regulated professions, have been halted and, sometimes, reversed. Progress with reforming Portugal's public administration is incomplete. There is still a lack of a comprehensive reform to effectively rationalise public administration. Coordination between the central and local levels is weak without homogenous implementing procedures across the different layers of the public sector. There are gaps in anticorruption measures and an overarching anticorruption strategy is not yet in place. In the judiciary, in spite of efforts made, efficiency indicators remain poor, especially for tax and insolvency courts. In public procurement, progress was made in transparency and reliability of data, while competition is still a problem and the use of direct awards remains high. Other weaknesses in tendering include limited exante and expost controls, lack of capacity, failure to provide satisfactory justification for the recourse of direct awards and contract splitting. 1. Economic situation and outlook GDP growth Portugal's economic recovery continues, supported by a rebound in net exports but held back by weak investment. Annual real GDP growth accelerated significantly to 1.6 % in the third quarter of 2016. This was due to a strong resurgence in exports of goods and services, which outweighed imports and increased the external contribution to economic growth to 0.7 percentage points. Domestic demand, which had strongly fuelled expansion in 2015, reduced its positive contribution to 1 pp. in the third quarter of 2016. This drop was driven by falling investment and slower growth in the consumption of durable goods. Investment is estimated to have improved only marginally by the end of 2016, due to stabilisation in construction activity, while employment growth is set to drive private consumption up. Overall, the Commission's 2017 winter forecast estimates that real GDP growth moderated to 1.3 % in 2016. Graph 1.1:Real GDP growth and its components Source: European Commission Economic recovery is expected to pick up modestly in 2017 and 2018. Growth in private consumption is also projected to remain modest, reflecting more stable consumption of durable goods, a sustained high level of household debt and higher oil prices. Coming from a low level in 2016, investment is set to gather pace in 2017. This is driven by the gradual increase in EU cofinancing during the new programming period and further support from external demand. However, risks to the forecast are tilted to the downside, as acceleration in growth will crucially depend on investment, which has so far remained volatile and sensitive to shocks. Inflation Inflation is projected to rise moderately in the medium term. HICP inflation increased to around 1 % in annualised terms towards the end of 2016 on the back of higher prices of energy and, to a lesser extent, services. The annual average rate however remained lower at 0.6 % reflecting downward energy price effects from the beginning of the year. HICP inflation is forecast to climb gradually to 1.4 % in 2018 under the assumption of higher oil prices and related secondround effects on energyintensive services. Labour market and social conditions The recovery of the Portuguese labour market continued in 2016. Employment growth continued at a robust pace of 2 % yearonyear in Q32016, mainly due to stronger demand for labour, especially services. At the same time, the unemployment rate fell to 10.5 % in Q42016. The activity rate for the 2064 age group remained close to its historical highs at just below 80 % in Q32016. Longterm unemployment remained high at around 60 % of total unemployment in 2016 and weighed negatively on potential growth. Youth unemployment, although decreasing, was also high at 26.1 % in the third quarter of 2016. The Portuguese labour market showed strong recovery over 20142016. The fall in unemployment between 2014 and 2016 was about 4.5 pps. faster than was to be expected on the basis of the past relationship between GDP growth and unemployment. This overshooting was the largest in the EU (European Commission, 2016a). The relatively jobrich recovery is probably linked to factors including strong wage adjustment in the previous years and with recent labour market reforms. Strong growth in tourism, particularly in 2016, is also estimated to have had a substantial positive impact on employment growth, as the sector itself and many related services are labour intensive. Overall, labour market conditions are expected to continue to improve over the medium term. Employment growth is however set to slow down over the forecast horizon. Along with a moderate decrease in the labour force, it is expected to bring the unemployment rate from around 11 % in 2016 to 9.4 % in 2018.

Graph 1.2:Activity, employment and unemployment rates (quarterly) Source: Eurostat Portugal has witnessed negative net migration flows since 2011. The average balance was about 32 000 people per year leaving the country between 2011 and 2014. More recently, the situation has been stabilising, along with improving labour market conditions. In 2015 net emigration declined to 10 500 people (or 1 per 1 000 inhabitants). Young people between 15 and 29 accounted for more than 40 % of total emigration between 2011 and 2014 and there are indications that the highskilled are overrepresented (European Commission 2016b). Hiring on permanent contracts continued, while labour market segmentation remains an issue. The Portuguese economy continued to add both temporary and permanent jobs in 2015 and 2016 (Graph 1.3). At the same time, the creation of permanent jobs was not sufficient to drive down the share of temporary contracts in the economy. Employees with fixed-term contracts accounted for 22.4 % of total employees in Q3-2016, one of the highest proportions in the EU. About a quarter of temporary employees move on to a permanent contract every year (27.3 % in 2015, stable from 2014 and slightly higher than the EU average of 23 % in 2014, EU-SILC data). The wage premium of permanent over temporary workers, not adjusted for the different composition of the two groups, is one of the highest in the EU (47 %, Eurostat 2014 structure of earnings survey). After adjusting for personal characteristics (such as age, gender and occupation) it falls to less than half of this, but it still remains among the highest. Graph 1.3:Employment by type (permanent, temporary, selfemployed), yearonyear changes Source: European Commission After two years of stagnation, the rate of persons atriskofpoverty or social exclusion declined in 2015. It reached 26.6 % ( ), still nearly 3 pps. above the EU average. Children are particularly affected, but their situation is slowly improving. Inwork poverty is one of the highest in the EU, with a sharp increase by 0.2 pps. between 2014 and 2015 (still, not reflecting the recent minimum wage increases as it is based in 2014 increases). The main reasons for this are lowquality employment and insecure labour relationships. Portugal has one of the highest income inequalities in Europe. Inequality, as measured by the income quintile share ratio ( ), has historically been higher than in other EU countries, though it was moving towards the EU average before the crisis ( ). This trend reversed since 2010 as market incomes of poorer households have been steadily eroded, due to rising unemployment and low wage growth. The taxbenefit system seems to have dampened the effect throughout the crisis, reducing inequality as measured by the Gini coefficient by about a third ( ). In 2015, there has been a modest decline in income inequality, driven by falling unemployment. There was a decline in wealth between 2011 and 2015 for all quintiles of the wealth distribution. However, this drop was more severe for the poorest quintile signalling a worsening of net wealth ( ) inequality which is still within the range observed in other EU countries for which data were collected in 2013-2014 (ECB 2016). Inequalities in access to healthcare remain critical. The gap between the poorest households and the richest in selfreported unmet needs for medical examination increased to 6.7 pps. in 2014 (EU average: 4.9), from just 2.3 in 2008 (see Section 4.3.2). Graph 1.4:Inequality of income distribution (S80/S20 income quintile share ratio) Source: European Commission External rebalancing The strong upswing in the current account over the past decade prevented a further deterioration of the NIIP but has not yet been sufficient to markedly improve Portugal's external position. The current account improved strongly over the past decade, from large deficits to modest surpluses. However, current and projected surpluses fall short of the estimated benchmark of 1.6 % required to halve the negative NIIP by 2025. Graph 1.5:NIIP and Current Account evolution Source: European Commission The most important component of the sustainable reversal of external imbalances was stronger exports while compressed imports played a smaller role. Improvements in competitiveness, resulting from adjustments to relative prices and product quality, enabled exports to make a growing contribution to reducing the currentaccount deficit, particularly between 2010 and 2013. From the second half of 2015, export performance was hindered by a weak global outlook, particularly in markets outside the EU. Yet, it improved significantly in the third quarter of 2016. This progress was driven mainly by exceptionally strong growth in tourism which, however, is not expected to sustain such a fast pace in the next few years. Moreover, the recent rebound in labour costs poses further risks to the country's external competitiveness. In the medium term, exports are forecast to grow in line with foreign demand. At the same time imports are expected to slightly outweigh exports, mainly due to increased investment. The improvement in external trade has been driven mainly by services, in particular tourism and transport. Both sectors have benefitted from positive external developments; a longerterm stable development would depend on increased investment and efficiency. While the negative trade balance of goods almost reached 13 % of GDP in 2008, it fell to around 4 % in 2016. A steady increase in the terms of trade has helped improve the trade balance of goods. Yet this price effect is expected to reverse due to the increase in energy import prices as of the second half of 2016. In addition, domestic demand is expected to push up imports over the forecast horizon. However, exports of goods in Portugal are still mostly concentrated in low technology and high labour intensive sectors. Portugal retains a comparative advantage in the production of construction material, textiles and leather production (Graph 1.6). The lack of technological innovation could hold back potential growth in the export sector in the medium term. The scope of specialisation in sectors with higher value added is relatively low, which limits the potential for expanding market shares. Therefore, the sustainability of the rebalancing process depends largely on the extent to which the structural challenges in the export sector can be resolved (see section 4.4.4). Graph 1.6:Revealed Comparative Advantage Index (goods) Source: European Commission The resurgence of exports over the past years was supported by a decline in labour costs and growing productivity. This led to a decline in the nominal unit labour costs (ULC) in 20102015. ULC started to rise again towards the end of 2015 and the growth rate picked up substantially to 2.5 % yearonyear in the third quarter of 2016. The rebound was more significant in the nontradable sector (Graph 1.7), particularly in construction. However, since 2016, ULC have increased across all sectors except agriculture. ULC are projected to increase only marginally from 2017 due to slower increases of labour costs. Risks to competitiveness remain as wages are expected to increase (see section 4.3.1) more than productivity (see sections 4.3.3 and 4.5). Graph 1.7:Nominal ULC, index 2001Q1=100 Source: European Commission Graph 1.8:Wage growth consistent with constant external competitiveness and actual wage growth Source: European Commission based on the methodology described in Arpaia and Kiss (2015) Nominal wage growth is estimated to have turned positive in 2016 in a context of declining productivity. Before that, wage dynamics and rising labour productivity helped boost competitiveness in almost every year since the crisis, as measured by the real effective exchange rate (REER) adjusted for ULC (Graph 1.8). In 2016, nominal wage growth is estimated to have turned positive but moderate (around 1 %). This was driven by the readjustment of public sector wages, an increase in the minimum wage, and wage hikes agreed in collective bargaining. Wage growth is expected to stabilise just slightly above 1 % in 2017 and 2018 and labour productivity just below 1 %, according to the Commission 2017 winter forecast. Price setting mechanisms, in particular minimum wage decisions, can hurt competitiveness if not compensated by productivity gains. Graph 1.9:Productivity decomposition in the overall economy Source: European Commission

Deleveraging Portugal's high private indebtedness ratios are expected to decline further, driven by output expansion and weak credit flows. Since the peak in indebtedness in 2012, the private sector has reduced its debt. Aggregate bank credit is expected to pick up only gradually in the medium term as debt levels of the non-financial sector remain high compared with international standards. Furthermore, the banking system profitability remains burdened by the large stock of nonperforming loans (NPLs). Contracting GDP pushed the debttoGDP ratio up until mid2014 while the subsequent resumption of growth helped reduce the debttoGDP ratio (see section 4.2.4). Overall, deleveraging is expected to slow down gradually but continue until a more sustainable level is reached ( ). Public finances Public finances continue to benefit from the moderate economic recovery and the favourable monetary policy stance. Having reached 4.4 % of GDP in 2015 (3.1 % of GDP net of oneoffs), the general government deficit is estimated to have fallen to 2.3 % of GDP in 2016, according to the Commission's 2017 winter forecast. Lower regular revenue collection is estimated to have been largely offset by the containment of expenditure, in particular due to lower public investment and the freezing of intermediate consumption, and by the revenue from the extraordinary debt settlement scheme PERES. Borrowing costs were moderated by the monetary policy stance (particularly via the European Central Bank's public sector purchase programme). The headline deficit is projected to fall further to 2.0 % of GDP in 2017, mainly due to a oneoff operation (a recovery of a guarantee to the BPP bank worth ¼ pps. of GDP), the continued moderate economic recovery and the continued effects of the ECB's public sector purchase programme. Risks to the fiscal outlook are tilted to the downside. They are linked to the uncertainties surrounding the macroeconomic outlook, the potential deficit impact of banking support measures (from the Caixa Geral de Depósitos recapitalisation, for example) and possible spending slippages. After the procyclical loosening of the fiscal policy stance in 2015, the fiscal policy stance is projected to have been and continue to be broadly neutral in both 2016 and 2017. After reaching 129 % at the end of 2015, Portugal’s gross public debttoGDP ratio is estimated to have risen to 130.5 % in 2016. The main reason for the increase was higher issuance of government debt for the planned recapitalisation of the stateowned bank Caixa Geral de Depósitos. Public debt net of central government deposits is estimated to have slightly declined by around 0.5 pps. of GDP in 2016.The gross public debttoGDP ratio is forecast to fall to 128.9 % in 2017 and to 127.1 % in 2018, due to primary budget surpluses and continued economic growth. Potential growth Potential growth perspectives are being dampened by the still low level of investment. While back to positive and increasing as of 2015, potential growth remains below the European average. Different factors are behind the longterm decline in Portugal's potential growth including deteriorating demographics (both due to emigration and ageing), low productivity growth and a capital accumulation process that was predominantly channelled to investments with low productivity. The observed negative investment gap was generated mainly by a fall in the productivity of capital or by overinvestment in the nontradable sectors. Thus, the decline in investment observed in Portugal since 2010 is driven mainly by a fall in investment in the non-tradable sector which then also implies an adjustment of investment to tradable, more productive, sectors. Portugal still faces quite a few obstacles that prevent more sustainable acceleration of capital accumulation. These are related to the vulnerability of the financial sector, weaknesses of the corporate sector, and some structural gaps in business environment (Box 4.4.1). Graph 1.10:Potential growth and its components Source: European Commission Outward migration and ageing are reducing the workingage population which weighs on the longterm growth potential. The projected decline in the workingage population is hindering the convergence of the country's growth potential towards the EU average. Emigration of youth (whose education levels are increasingly higher than in the rest of the workforce 67 % being mid or highly educated of those between 25-34 against only 38 % of population above 35) combined with high levels of youth unemployment in the wake of the crisis involves the risk of erosion in human capital, with a negative impact on potential growth. Table 1.1:Key economic, financial and social indicators - Portugal Source: European Commission, ECB 2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Portugal in 2016 ( ) has to be seen in a longer term perspective since the introduction of the European Semester in 2011. Portugal successfully completed the three year EUIMF financial assistance programme in 2014. In the course of the programme, it adopted a wide range of structural reforms. While implementing the programme, Portugal received only one countryspecific recommendation to meet the programme commitments ( ). As of 2014, Portugal returned to the regular cycle of EU economic surveillance under the European Semester and received a full set of recommendations. The reform efforts over the period 20112016 have helped Portugal to become more competitive and attractive for investors. Portugal carried out an ambitious fiscal consolidation underpinned by a number of fiscal governance and structuralfiscal measures (organisation of public administration, public finance management, tax administration, SOEs and PPPs). A number of measures were carried out to unwind the public and private, internal and external imbalances and increase the growth potential, while mitigating negative social impacts. In light of the need of correcting the country's imbalances, the authorities introduced reforms to product markets (energy, housing, services, telecommunications, and transport), labour market (wage setting, working time arrangements, individual dismissal, unemployment benefits, active labour market policies), education system (increased number of compulsory education years, enhanced vocational and professional training, enhanced external evaluation and transparency), business environment (licensing, services and regulated professions), judicial sector (new insolvency, arbitration, competition laws and new judiciary map). Measures were also targeted at strengthening the banking sector. Despite those reforms, policy gaps persist regarding product and services markets, corporate debt restructuring, fiscal issues and selected areas of the labour market. Overall, Portugal has made limited progress ( ) in addressing the 2016 country-specific recommendations. There has been limited progress towards making public finances more sustainable (CSR1). A solid budgetary consolidation relies on the timely and strict implementing the budget framework law, reviewing and rationalising public spending and further improving revenue collection. The restructuring of stateowned enterprises, to make them fiscally sustainable, has not still been fully addressed. The reliance of the pension system on budgetary transfers has only been reduced to a limited extent thus creating intergenerational inequalities. In the health sector, the government has adopted measures aimed at promoting disease prevention and public health policies. At the same time, given the lack of sound budget planning and implementation in hospitals they are not enough to guarantee arrears clearance and spending control. Portugal made limited progress in ensuring that the minimum wage is consistent with the objectives of promoting employment and competitiveness across sectors (CSR2). After consulting the social partners, the government has raised the minimum wage by 5.1 %, beyond inflation and average productivity developments. While increasing aggregate demand and contributing to reducing inwork poverty, by growing faster than overall compensation per employee and covering an increasing share of workers, it may make the hiring of especially lower productivity workers harder. The government has established a structure to monitor the impact of minimum wage developments. Its quarterly reports are discussed with social partners. Some progress has been made regarding the recommended reforms on the labour market (CSR3). While limited progress has been observed in effectively activating the longterm unemployed and coordinating employment and social services there is some progress in reducing labour market segmentation. A study has been conducted into the effectiveness of active labour market policies. Based on its results, the government redesigned its employment support programme to promote hiring on openended contracts though the number of people covered by this measure is limited. At the same time, longterm unemployment remains high. The introduction of one stop shops for both employment and social services is also planned, but has not yet been implemented. Progress in the financial sector (CSR4) remains limited. Despite some actions taken recently to address the high stock of non-performing loans, there is no comprehensive strategy. Efforts to provide alternative means of financing remain limited. The authorities have published a strategic plan to support the capitalisation of companies (the Capitalizar Programme) which has yet to be fully implemented. The debt bias in corporate taxation is addressed by broadening the scope of the allowance for corporate equity regime. Some progress has been observed in removing regulatory barriers and improving the business environment (CSR5). The authorities have introduced some measures to make the justice system more efficient, especially as regards organisational improvements in the courts. However, the sector's overall performance remains low, especially where dealing with tax litigation is concerned. Measures are ongoing to improve transparency and reliability of public procurement data and practices. The government has established quarterly monitoring and reporting procedures related to local and regional public private partnership and concessions, but the relatively high use of direct awards remains a concern. Licensing has been reformed, but its uneven implementation across different layers of the public administration is detrimental to confidence and investment. Existing regulatory barriers in some business services sectors still prevent resources from being allocated efficiently. Portugal is developing a set of measures to improve universitybusiness cooperation and the commercialisation of knowledge. The government is currently working on an international revision of the higher education system. Nevertheless, an overall strategy to foster cooperation between universities and the business sector has not so far been implemented.

Table 2.1:Summary table on 2016 CSR assessment Source: Commission Services 3. Summary of the main findings from the MIP in-depth review The 2017 Alert Mechanism Report called for further indepth analysis to monitor progress in the unwinding of the excessive imbalances identified for Portugal in the 2016 MIP cycle. The selection was also motivated by the fact that Portugal was identified as having excessive imbalances in spring 2016, so that a new IDR is needed to assess how these imbalances evolve. The excessive imbalances arise from external liabilities, high levels of private and public debt levels and high unemployment in a lowgrowth environment. Analyses integrated in this Country Report provide an indepth review (IDR) of how the imbalances identified have developed. In particular, analysis relevant to the IDR may be found in the following sections: Public finances and taxation (see Section 4.1); Financial sector: banking sector, access to finance, private indebtedness, vulnerability linked to the highly negative net international investment position (see Section 4.2); Labour market: high youth and longterm unemployment (see Section 4.3); Investment: external competitiveness, private and public investment, business environment (see Section 4.4); Sectoral policies: R&I, competition in product and services markets (see Sections 4.5.1 and 4.5.2); Public administration: efficiency of public administration, public procurement, judicial system (see Section 4.6) 3.1.Imbalances and their gravity The net international investment position (NIIP) remains negative. It was close to 110 % of GDP in 2015, one of the most negative NIIPs in the EU, well beyond its estimated prudential level of 48 %. Moreover, its composition is tilted towards marketable debt rather than more stable FDI and equity components. Improved growth prospects and continuous current account surpluses of around 1.6 % of GDP per year would be required to halve the negative NIIP and reach a more sustainable position by 2025. Some deleveraging efforts, in particular for households, notwithstanding, the private debttoGDP ratio remains high. Private debt is still well above prudent levels in a context of also high government debt and low potential growth and inflation. Total household nonconsolidated debt reached 76 % of GDP in early 2016 and nonconsolidated corporate debt was over 117 %. Corporate indebtedness remains amongst the highest in the EU and deleveraging needs in this sector are assessed at between 10 % and 20 % of GDP ( ). The share of nonperforming loans (NPLs) has stabilized although at a high level over the recent quarters, while it is still increasing in some sectors, in particular construction, real estate and trade. The large stock of corporate nonperforming loans, low profitability, exposure to sovereign debt risks and weak capital buffers are putting pressure on the banking sector. The deterioration in the quality of assets, in particular in the corporate sector where the ratio of overdue loans was 16.2 % in the end of first half 2016, weighs on the banking sector's aggregate balance sheet. It is one of the factors, along with demand for loans and low capital buffers to impede the productive allocation of credit and investment. Graph 3.1:Banking sector situation and domestic debt levels Source: Eurostat and ECB The level of public debt implies risks to fiscal sustainability, making Portugal vulnerable to adverse shocks. The government debttoGDP ratio remains high at around 130 %. Changes in financial or economic conditions could substantially increase financing costs. Moreover, the pace of downward adjustment hinges on the authorities' ability to maintain fiscal discipline and implement effective measures to guarantee the required fiscal adjustment. Portugal still faces challenges in the labour market. Although unemployment has been declining, youth and longterm unemployment remain high. At 26 % in Q32016 youth unemployment is among the highest in the EU. Longterm unemployment at 6 % in the same period represents more than half of all those unemployed. Moreover, labour market segmentation continues to hinder productivity growth, leaving young people — who are more educated on average — with unstable contracts while labour market adjustment has had profound social implications. High levels of longterm and youth unemployment increase the risk that jobless people will disengage from the labour market, gradually losing their skills and employability. 3.2.Evolution, prospects, and policy responses The net international investment position has improved somewhat from its low level. The current account has moved to a broadly balanced position since 2013. Small surpluses are expected from 2016 onwards, also in cyclicallyadjusted terms and when controlling for REER effects. The NIIP is expected to continue slowly improving on the back of moderate nominal growth and modest current account surpluses which, on their own, are not however sufficient for a rapid return to a more sustainable external position. Private sector debt is slowly declining, while the still high levels of nonperforming loans represent obstacles to new lending. Private sector deleveraging has continued moderately in a difficult situation characterised by low banks' profitability, high NPLs and reduced capital buffers. Along with most EU countries affected by a high level of NPLs these have either stabilised or reduced in recent years, with the exception of the corporate segment of the portfolio, where the NPL ratio continued to increase. Measures have been taken regarding the financial sector, access to finance and insolvency procedures. The level of private debt imbalances remains high, while alternative means of financing are still limited. Key areas of concern are Portuguese banks' low profitability, asset quality (the ratio of NPLs is high and increasing in the corporate segment), thin capital buffers, exposure to sovereign debt, and high corporate debt overhang. The main challenge is to maintain orderly corporate deleveraging while minimising the ensuing burden on the economy. Public debt has stabilised at a high level. A contracting economy and high budget deficits put the gross public debttoGDP ratio on an increasing trend until 2013. Fiscal consolidation was difficult in a recessionary environment. The economic recovery has helped stabilise the gross public debttoGDP ratio at around 130 % since 2014. On the back of the projected continued moderate recovery and primary surpluses, it is expected to decline somewhat, to around 124 % of GDP by 2027. Adverse shocks, such as an increase in interest rate, may put Portugal’s public debt ratio on an unsustainable path. Although measures have been taken to make public finances more sustainable, challenges remain. The financial viability of the StateOwned Enterprises (SOEs) is not yet ensured. This is particularly true of highlyindebted SOEs, most of which are in the transport sector. In view of demographic and economic developments, the affordability of public pensions is under pressure in the short term. Even though partially tackled, there are also challenges to the short and longterm sustainability of the healthcare sector. Historically the health system has run losses and has been unable to clear its arrears.

Labour market duality remains an issue. The Portuguese economy continued to add both temporary and permanent jobs in 2016, but job creation on permanent contracts was not strong enough to lower the share of temporary employees, particularly among young workers. Measures were taken in the area of employment support to promote hiring on openended contracts, but their expected impact on reducing segmentation appears limited. A rebound in potential growth to converge with the EU average would address mediumterm challenges. Persistent bottlenecks and rigidities in the product and labour markets still imply limits to supply and demand of labour and thus to potential growth. This refers in particular to obstacles to job market access for young people and the longterm unemployed. High leverage in the private sector and high banks' stocks of NPL weigh on new credit to firms which would allow for a positive capital contribution to potential output. At the same time, a tight fiscal situation poses risks for public debt sustainability and also limits the productive use of public capital resources. Given the estimated need for deleveraging, inflows of nondebt financing such as FDI, could make a valuable contribution to expanding the country's investment and growth potential. The current imbalances limit the resilience of the Portuguese economy to shocks, making it less capable to adapt to a constantly changing environment. Portuguese GDP growth is volatile relative to the EU average and remains vulnerable to the high volatility of the terms of trade. To buffer the economy from these and other shocks, reducing the stock of public debt would create the fiscal space needed to enable fiscal policy to offset future shocks. At the same time reducing corporate debt would make the private sector more flexible in dealing with sudden shocks, mitigating the spillovers which shocks to firms have on the rest of the economy. Lower unemployment would prevent major negative impacts on aggregate demand, which could occur through a decline in consumption or an expansion in unemployment benefits. Overall, these adjustments would also help improve the NIIP, Measures designed to improve export competitiveness could also help. While some progress has been made, there is further potential for structural reforms in several areas. Progress has been made so far in improving the efficiency of the Portuguese public administration. However, there is a lack of rationalising and modernising central, regional and local public administration. Measures have been taken to improve the operation of the judicial system, but efficiency indicators remain very poor especially for tax courts. It is still not possible to evaluate and monitor the housing market reforms properly. There is no systematic monitoring and reporting underpinned by precise and relevant data on key drivers of that market. There have been improvements in the dedicated online platform for public procurement which provides a large amount of data on public contracts. However, transparency remains a challenge for publicprivate partnerships. This is particularly applicable to the local and regional level, and to concession contracts. Portugal has one of the most restrictive business services regulation in the EU. As a result, productivity growth remains limited, it is more difficult for new players to enter the market, and the price for services is higher than it should be. There are outstanding barriers to access to professions and to more simplified authorisation which adversely affect external and internal competition within the Portuguese economy. Unfavourable framework conditions and weak links between public and private sector still limit Portugal's innovation performance. Delays in reforming the transport sector are hampering the sector's competitiveness. State owned transport companies lack a longterm financial sustainability plan to support future investments. The current rail infrastructure is not being used to its full potential thus compromising the performance of the freight sector. The renegotiation of existing port concession agreements and a new framework for port concessions aim at making Portuguese ports more competitive. Yet, both are being delayed. High structural costs in the energy sector together with an excess of installed capacity compromise the sustainability of the system. The government is putting forward measures to recover past undue rents and eliminate existing ones but a high tariff debt and a concentrated retail market put pressure on enduser prices. 3.3.Overall assessment Portugal continues to face important sources of imbalances arising from high external, private and government debt in a context of unemployment and lowgrowth. Private debt is slowly declining, while government debt has stabilised against the background of remaining consolidation needs. The competitiveness gains that materialised over the past few years are bottoming out. The high stock of nonperforming loans, which has not yet stabilised, continues to put pressure on bank profitability and their workout could imply capital gaps that might require state intervention. Various policy measures have been taken to help reduce imbalances, but significant gaps remain. Despite some improvement in relevant flow indicators, Portugal still suffers from major sources of external and internal imbalances. Besides very high private and government debt levels persistent weaknesses concern, the exposure to sovereign debt risks, and thin capital buffers in the banking sector, as well as limited access to finance for corporations and SMEs. A number of policy measures have been taken to restructure the financial sector, ensure adequate capital buffers, and support the reduction of nonperforming loans. Despite the restructuring of major banks, recapitalisation programmes and reforms of the insolvency framework, progress with NPL reduction remains slow and further recapitalisation needs remain likely. Public finances are not yet firmly on a stable footing; despite some progress in moving towards a spending review and addressing health expenditure sustainability, action on the front of StateOwnedEnterprises restructuring remain limited. Bottlenecks to productivity growth remain related to innovation performance, restrictions in some services and regulated professions, the public administration, and network industries. The labour market is improving but youth and longterm unemployment still weigh on the employment and social recovery. There is still no comprehensive growth strategy. Regulatory barriers and rigidities in labour and product markets continue to hamper business growth, competitiveness and investment in Portugal.

Table 3.1:MIP assessment matrix - Portugal 2017 (Continued on the next page) Table (continued) Source: Commission services 4. Reform priorities 4.1. Public finances and taxation 4.1.1.Fiscal policy (public debt and debt developments)*( ) General government debt remains high. In the context of the global financial crisis and subsequent recession, very high fiscal deficits, the reclassification of offbalance sheet items and entities into the general government perimeter and stabilising interventions in the financial system resulted in a steep rise in general government debt by over 30 percentage points of GDP between 2010 and 2013. Subsequently, the gross debttoGDP ratio has stabilised at around 130 % of GDP since 2014, the third highest public debt level in the euro area. The projections in the following analysis are based on the Commission’s 2017 winter forecast. Following the downward revision in projected proceeds from sales of financial assets, including Novo Banco, the fall to around 126 %, previously expected to take place in 2016, is now not expected until 2022. The primary balance, projected to have reached 2.1 % of GDP in 2016, is forecast to be at 2.5 % in 2017 and 2.2 % in 2018, thereby moderating future financing needs. The gross public debttoGDP ratio is expected to fall moderately in the short term and to stabilise in the medium term. While public debt is considered sustainable under plausible scenarios, debt dynamics are vulnerable to adverse shocks. Supported by the projected continuing economic recovery and expected primary surpluses, the debttoGDP ratio is expected to fall from 130.5 % in 2016 to 128.9 % in 2017 and 127.1 % in 2018. Model simulations of debt sustainability have been carried out that incorporate the scenario of the 2017 winter forecast until 2018 and other technical assumptions for the medium term ( ). For the baseline scenario, the results suggest that, following a moderate decline in the shortterm, the debt ratio will stabilise in the medium term at around 124 % of GDP (Graphs 4.1.1 and 4.1.2). Graph 4.1.1:Combined interest rate and GDP growth shock (chart to be updated) Source: European Commission The stabilising debttoGDP trajectory in the baseline scenario is sensitive to potential rises in sovereign yields and vulnerable to adverse economic developments. Overall, the debt sustainability analysis reveals that the debt stabilisation path of the baseline is broadly robust across a number of reasonable scenarios. Yet, plausible shocks could considerably worsen the dynamics of Portugal’s public debt (Graph 4.1.1). Potential shortfalls in nominal growth, sharp interest rate rises or decreasing fiscal efforts could put the public debt ratio on a nonsustainable path. An unsustainable debt trajectory could adversely affect Portugal’s economic stability and could have negative outward spillovers via the sovereign risk channel. Graph 4.1.2:Fiscal consolidation Source: European Commission The high level of government debt is a heavy burden on public finances. High public debt implies a smaller fiscal margin for manoeuvre to absorb adverse macroeconomic shocks and cope with possible interest rate rises. The high interest bill (projected at 4.3 % of GDP in 2016 as compared to 2.2 % on average for the euro area) also restricts scope for public investment spending. In the absence of further fiscal consolidation and growthenhancing structural reforms, safeguarding fiscal sustainability and significantly reducing the debt path will be a challenge. The very high debt ratio implies a significant adjustment burden, which requires the conditions for falling debt to be steadily maintained in the coming decades, including sustained economic growth. Sustainability can be safeguarded through permanent budgetary discipline, in line with the requirements of the Stability and Growth Pact (Graph 4.1.2). The implementation of the reformed budget framework law and enhanced revenue collection could contribute to fiscal adjustment. Healthcare expenditure now accounts for the largest share of ageing costs, with corresponding implications for longterm sustainability. Recent reforms appear to ensure the longterm sustainability of the pension system. 4.1.2.Short-, medium- and longterm sustainability (including pensions and healthcare)* Fiscal risks assessment indicators point to a low risk in the short term but higher risks in the medium term. The shortterm indicator for fiscal risk, S0, points to a low risk of fiscal stress, as the indicator for 2016 is below its critical threshold value. Rather than expressing the need for structural adjustments, this indicator provides a composite index that highlights shorterterm risks stemming from fiscal, macrofinancial and competitiveness variables. Despite this favourable assessment, some vulnerabilities persist, associated with the shortterm financing needs of public debt, the stock of private debt and the net international investment position. In the medium term, Portugal is classified as being at high risk based both on the fiscal sustainability indicator S1 and the debt sustainability analysis (see Debt Sustainability Monitor 2016). In particular, the fiscal sustainability indicator S1 reaches a value of 6.0 pps. of GDP (based on the Commission 2017 winter forecast), indicating that a cumulative improvement in the structural primary balance of 6.0 % of GDP (relative to the baseline) would be required over 5 years from 2019 onwards, in order to reach the reference value of 60 % of GDP by 2031. These risks are mostly related to the distance of the debtratio from the 60 % reference value.

Longterm fiscal risks in the country are assessed as low, largely thanks to pension reforms. The S2 indicator for longterm fiscal risk assessment shows that an upfront fiscal adjustment limited to 1.2 pps. of GDP is required to stabilise public debt in the long term. This low sustainability risk has improved following recent pension reforms. Yet, given a structural primary balance of 1.7 % of GDP in 2018, the future required level of structural primary balance would be 2.9 % of GDP. If agerelated expenditure were to increase as indicated in the 2015 Ageing Report (European Commission 2015), the S2 indicator would require an adjustment of 1.2 % of GDP, to make allowance for risks arising mainly from healthcare spending. High and rising ageing costs pose still a risk to fiscal sustainability. In the medium term, higher fiscal risks are expected to be related largely to the costs for financing pensions and the need to reverse the ongoing accumulation of arrears in the healthcare sector. Despite recent reforms, public pension spending is expected to rise over the next 10 years until benefit and coverage curbs take effect. This leads to an overall decline in pension spending of about 0.7pp of GDP between 2013 and 2060 (European Commission 2015). The situation is different for the healthcare sector, which represents the largest share of Portugal's ageing costs and which is expected to post the EU's largest by 2060 (2.5 % of GDP against 0.9 % EU average). Further, the continued accumulation of delayed payments in hospitals adds more strains to debt reduction and sustainability in the very short term. Several reforms have improved the long–term sustainability of the pension system. Pressure for the sustainability of the debt path is mostly related to the large distance of the present debttoGDP ratio from the 60 % reference value, rather than to pension related costs. Past measures include introducing disincentives to early retirement, raising the pensionable age from 65 to 66 for both sexes, and linking future increases to life expectancy at age 65. The automatic adjustment of pension to life expectancy has done much to reduce pension costs in the longterm. Short to mediumterm costs however remain high. New measures in the pension system are explored, but it is unclear how they will affect cost reduction. The government has launched a comprehensive study of the pension system with measures expected to be applied in 2018, at the earliest. These measures might entail a reduction in the early repayment penalties for workers with about or more than 40 years of service. They could include harmonising current benefit schemes and meanstesting procedures. Overall, the authorities are committed to issuing a package of new measures that will be budgetneutral. It will not alter the current plan to eliminate extraordinary budgetary transfers to the pension system by 2019. In the meanwhile, the 2017 budget includes the earmarking of a new progressive tax on real estate assets to the social security's Financial Stabilization Fund (worth EUR 160 million in 2017 according to the 2017 Budget). The government is presenting this earmarking as an alternative to excessive reliance on conventional budgetary transfers. Yet, overall the expenditure side of the sustainability of the pension system in the short to mediumterm remains unaddressed. Portugal has made efforts to ensure access to quality healthcare. Several steps have been taken to make the healthcare sector more efficient and sustainable. Procurement of goods and services is now centralised, creating important savings to the National Health Service. The use of generics eligible for public reimbursement has been expanded, pharmaceutical prices have fallen, waiting lists have been cut and the number of family health units has increased. More recently, the authorities have set up a reform working group with a three year mandate. The latter has focused mainly on i) improving the IT system (including eliminating duplicate records, records of deceased patients etc.), ii) human resource planning aimed at recruiting qualified staff in difficult areas, iii) pilot projects in areas with gaps in the National Health Service. At the same time, access to primary healthcare continues to expand, while the emphasis is increasingly shifting on prevention measures, such as vaccination campaigns (see section 4.3). Weak accounting and managerial controls lie behind the rising stock of arrears in hospitals, which undermines the health sector's viability. While the hospital reform continues, budgetary planning and implementation in the hospitals remain an important issue. Late payments (arrears) continue to increase, denoting weaknesses in accounting control mechanisms and managerial practices. The stock of arrears in the health sector has increased by EUR 90 million from December 2015 to December 2016. Yet, in October the increase from December 2015 was about 307 million (or 68 %) as arrear repayments occurred mostly at the end of the year. On the one hand, these were possible thanks to the use of centralised allocation to the reversal of wage cuts, the use of some centralised appropriations and the authorisation of using cash balances at the end of the year. On the other hand the extension of the tax on alcoholic drinks (IABA) to sweetened drinks (the levy on drinks with added sugar should be worth EUR 80 million in 2017) is earmarked to address the sustainability of the National Health Service. While these measures sufficed to reduce the existing stock of arrears, they do not entirely address the factors behind their continued accumulation. The most recent report on budgetary execution (October 2016) confirms the increasing indebtedness of stateowned hospitals. Accurate and balanced budgeting, enhanced controls and effective enforcement of the commitment control law could help improve efficiency and quality in this sector. An inadequate system of incentives for the compliant hospitals may lead to overspending. In spite of short term savings in the health care sector, Portugal lacks a comprehensive longterm strategy to addressing the healthrelated costs of ageing. The health sector is covered by the recently launched spending review. Savings from the sector are expected to amount to EUR 134 million between 2017 and19. Yet, there is still a need to clarify in more detail how these savings will be achieved. Given the major cost compression undertaken during the economic adjustment programme, any new saving measures need to be carefully designed so as to avoid compromising access to primary healthcare. 4.1.3.Fiscal framework, public administration and SOEs* Implementation of the reformed Budget Framework Law adopted in 2015 has been slow. The Law is designed to make budget units more accountable, strengthen the medium to longterm focus of public finances by introducing programmebased budgeting and align the deadlines for presenting of the stability programme and the draft budget to Parliament with European Semester requirements. It allows for a threeyear transitional period to apply most new features. Albeit nearly a year late, the authorities have recently approved the rules on the operation of the new Budget Framework Law implementation unit ( ), a first milestone in its implementation, and have set a timetable for 2017 activities. However, the decree law setting up the new budgetary programmes is still outstanding. Given the cumulated delays in the implementation of the new Budgetary Framework Law, there is a risk that this may not be completed by the 2018 target. The current spending review appears would benefit from a more comprehensive and strategic approach. The authorities have started a spending review that focuses mainly on the health and education ministries, state owned enterprises, (centralised) public procurement and real estate management. This review falls short of a comprehensive approach that would encompass the public sector at large and be guided by a set of concrete savings targets ( ). On the contrary, arrears in hospitals have been growing since the beginning of the year, indicating a lack of control over spending especially in the health sector. There are setbacks in public administration reforms. Ongoing public employment reforms have not led to the expected containment of the wage bill. Despite the civil servants rotation policy (2:1 replacement rule) introduced in 2016, the wage bill is on the rise, pointing to some weaknesses in the efficiency of this reform and possible negative implications from the return to the 35hour working week for public employees, mainly in the healthcare sector. The scope of the revised requalification scheme has also been reduced. Local administration reform measures have been delayed. Following some delays, the Municipality Support Fund (FAM – a debt workout mechanism for overindebted municipalities) has only recently started disbursements. There is still no framework to guarantee the financial sustainability of state owned enterprises. State Owned Enterprises (SOEs) monitored by the Ministry of Finance's UTAM unit had a total indebtedness of EUR 32 billion in the second quarter of 2016. However, there is no concrete plan to tackle this large debt stock. Transport sector firms account for most indebtedness. The rail and road infrastructure manager (IP) alone represents 27 % of total indebtedness of SOEs reaching 62 % when added to the rail transport company (CP) and the Lisbon and Porto metros. IP has recently signed a fiveyear Public Service Obligation contract, but a more longterm operation of sustainability has not been defined. The authorities are revising the operating and financing model for SOEs providing urban transport in Lisbon and Porto. However the high debt and negative operational results of the cities' metro system remain worrying and their long-term sustainability is still not ensured. New investments are being planned, but a governance scheme and financial framework to ensure longterm sustainability is still being defined. In the case of Lisbon’s bus transport company Carris, it was decided to transfer ownership to local government while the debt will remain with central government. The reinstatement of career progression for employees of SOEs may further adversely affect the firms’ financial situation. The burden placed on public finances by public private partnerships (PPP) is set to continue. Extraordinary subsidies and compensatory payments to IP are expected to more than double compared with 2016 mostly as a result of the five year Public Service Obligation contract recently signed. The cost of PPP contracts until their end has been revised up by over EUR 500 million with respect to the value estimated in the 2016 budget as the amounts were recalculated using 2017 prices. The Court of Auditors also recently drew attention to the fact that the current monitoring does not take full account of the risk to public finances. The Government intends to improve oversight of spending by SOE's through an exante and expost assessment of investments, activities and their financial impact together with a more regular monitoring. But this does not amount to a comprehensive plan to tackle indebtedness and longterm financial sustainability by setting concrete targets. 4.1.4.Taxation* Measures have been proposed to improve tax compliance and the tax administration's efficiency. The authorities are taking steps to make the tax administration more efficient by recruiting new tax auditors and gradually reorganising the tax administration's local presence. Measures to further step up the fight against tax evasion and fraud are also under way. The dedicated Taxpayer Services Department for large companies is now expected to take over wealthier households as well. An annual plan for combating tax evasion and fraud is set to replace the current threeyear programme, thus enabling the Tax Administration to strengthen its oversight. Portugal is imposing further requirements as regards banks' obligations to provide data on all non-residents bank accounts, resulting from the exchange of information with other countries, limits on cash payments and the end of bearer shares. Dealing with taxes is timeconsuming and complex. The average number of payments necessary to comply with all tax obligations is small (8). At the same time, the average number of hours needed to meet such obligations (243) remains the 5th highest among EU countries (World Bank, 2016). However, Portugal continues to simplify its tax administration with a view to reduce tax evasion and improve tax compliance. Following past efforts to improve the efficiency of the tax administration, there are plans for a series of new administrative simplification measures for several taxes between 2016 and 2017 under the Simplex Programme. A number of measures were already adopted in 2016, (e.g. nonhabitual residents may register online for Personal Income Tax purposes, and the invoicing rules for the Value Added Tax (VAT) special regime for small and mediumsized enterprises were simplified). Minor tax policy shifts have been implemented. As set out in the government programme and the 2016 budget, the introduction of a lumpsum allowance per child, replacing the family quotient introduced in 2015, is now effective. The reduction in VAT on restaurant food to the intermediate rate of 13 % took effect on 1 July 2016. Reduced VAT rates are still used heavily, although VAT reforms during the crisis had broadened the tax base to some extent ( ). Portugal's VAT gap as a percentage of theoretical VAT liability of 12.5 % is close to the EU average of 14.0 %, indicating that the efficiency of VAT collection is around the average. However, Portugal's VAT policy gap of 50.9 % is clearly above the EU average of 43.8 %. This is because it has a high VAT rate gap (11.1 % compared with an EU average of 5.3 %), while the exemption gap is in line with the EU average. The VAT rate gap shows the reduction of revenue (as a percentage of GDP) due to the use of reduced VAT rates. The still broad use of reduced rates implies significant revenue losses. The authorities plan to reform several taxes but the timelines are not yet defined. These reforms include revising the number of income brackets in the Personal Income Tax and making it more progressive while creating a salary supplement for lower wages; and other tax reforms addressing firms' chronic undercapitalisation. The 2017 budget includes revenue from the extension of two taxes that is going to be fully earmarked to the sustainability of the national health system and the Social Security's Financial Stabilisation Fund. These are: (i) the extension of the alcoholic drinks tax (IABA) to include sweetened drinks, which is forecast to be worth EUR 80 million in 2017; and (ii) the new progressive tax on real estate portfolios (portfolios above EUR 0.6 million, on top of the existing recurrent real estate tax IMI that has been relatively low in EU comparison) which should yield EUR 130 million in 2017. Despite the need to address some outstanding issues, ensuring the stability of the tax system is also considered a key aspect of the country's capacity to attract investment. Despite some positive recent developments, the debtequity tax bias in corporate taxation remains a challenge. Investments financed by debt are taxed less than those financed by equity. As a result, the difference in the cost of capital for investments financed by debt and equity in 2016 was the fifth highest in the EU and well above the EU average ( ). In recent years, the government has tried to tackle this problem by introducing new rules on limitation of interest deductions and an Allowance for Corporate Equity (ACE). Further measures are envisaged as part of a programme adopted in July 2016 (Programa Capitalizar), though they are not yet in place. In line with the Capitalizar programme, the 2017 state budget law widened the scope of the allowance for corporate equity. The impact of these measures remains to be seen and will be closely monitored. The impact of an ACE depends on its design features and notably its antitax avoidance framework. An alternative, more robust measure, the Allowance for growth and investment, was recently proposed by the Commission within the Common Consolidated Corporate Tax Base ( ). 4.2. Financial sector and indebtedness

4.2.1.Banking sector* The banking system's main challenges remain weak asset quality, thin capital buffers, low profitability and relatively high exposure to Portuguese sovereign debt. While asset risk has broadly stabilised, banks profitability in 2016 remained weak because of a sluggish business environment, high costs for low quality assets, and lower trading gains than in 2015. In seeking to optimise assets' allocation, banks have slightly increased exposure to domestic and higher yielding foreign sovereign debt while some lenders have a large exposure to companies tied to emerging market economies that have recently underperformed on the market. However, the structure of banks funding is improving, with a loantodeposit ratio close to 100 % since end2015, a higher share of customer resources, and slightly lower funding from the European Central Bank. Banks carry on the deleveraging of their balance sheets while new loans to households are on the increase. Total banking system assets continued to decline, falling by 24 % between the end of 2010, when the deleveraging started, and Q22016. As in previous years, the fall in the credit portfolio contributes most to the fall in the system's assets. Looking at recent trends in lending volumes, by the end of 2015, total credit to households shrank by 2.2 % yearonyear driven by the fall in loans for house purchase (2.9 % yearonyear), whereas loans for consumption and other purpose rose by nearly 1 %. In the same period, loans to Portuguese firms (adjusted for sales of credit portfolios) fell by 1.3 % yearonyear. Nevertheless, gross flows of new bank loans to households increased considerably in 2015. The volume of new mortgage loans is now comparable with the average last seen in 2011. Consumer lending is once again strong reflecting more consumer confidence and backed by easing credit standards and low interest rates. Assets quality and low profitability continue to put pressure on the system’s solvency levels. All Portuguese lenders comply with the minimum capital requirement of 8 %, while the average Common Equity Tier 1 (CET1) ratio for the banking system was 12.1 % in Q22016, 0.8 percentage points higher than at the end of 2014 and stable if compared to the end of 2015. Nonetheless, Portuguese banks are currently among the weakestcapitalised credit institutions in the Eurozone. This highlights dire solvency pressures coming mostly from the difficulty for banks to generate capital from internal resources, through earnings retention. Such pressures are set to continue in 2017. Portuguese banks are facing increased regulatory and prudential capital requirements through additional capital buffers imposed through Pillar II requirements and also on Portugal's systemically important institutions. The profitability of Portuguese banks is still very weak. After four years of losses, the banking system became profitable in 2015, given a substantial decrease in impairments and provisions, and large trading gains booked from the sale of sovereign bonds. In 2016, however, most banks just have broken even as the systemwide return on equity at the end of June 2016 was just 0.3 %. This reflects a significant fall in income from financial operations and an increase in the flow of impairments. By contrast, net interest income increased, driven by a larger reduction in interest costs than in interest income, following the repricing of deposits at lower rates. The overall differential between the headline credit rate and the average remuneration rate paid by banks on deposits is gradually rising. Ongoing deleveraging, the relative importance of loans with indexed interest rates and low spreads in the banks’ credit portfolios negatively impacted on the income from credit to customers. Overall, recurring revenues remain strongly affected by the low interest rate environment and subdued business levels. Other income items such as net commissions and income from international activity have accounted positively to revenue generated in 2015 and 2016. Portugal's banking sector compares rather unfavourably with most of the euro area countries when it comes to efficiency figures. The costtoincome ratio remains locked at 60 %. The average efficiency of banking operations has hardly improved with costtoincome at 59.9 % at the end of 2015 and 60.4 % in mid2016, only a fall of 5.1 percentage points from 2014. Nevertheless, efforts are being made to adjust the structure of banking operations and employment to the new environment – in that context the top nine lenders in the country have cut operational costs by 6 % over the first three quarter of 2016. Taking into account the banks’ limited capacity to generate gross income in the current macroeconomic environment, the recovery in the Portuguese banking system’s profitability is likely to rely mainly on continuously reducing operational costs while at the same time safeguarding the integrity of the risk assessment and internal control processes among banks. The high amount of nonperforming loans continues to weigh on the banking sector's aggregate balance sheet. The nonperforming loan (NPL) ratio ( ) remains high (20.1 % against 19.6 % in end-2015) and still rising for some sectors of the economy, in particular nonfinancial corporations, active in the construction and real estate sectors. These corporations have also a high share of overdue loans for more than two years. In contrast, bad loans in manufacturing, hotels and restaurants have stabilised and even improved. The quality of credit to households is relatively of better quality and seems to have stabilised over the past year. In addition to high levels of NPLs, some large banks have a high share of foreclosed real estate assets on their balance sheet, which puts additional asset risk pressure on the banking system as a whole. Given moderate economic growth prospects, the ratio of nonperforming loans is not expected to improve substantially. Without decisive action, the stock of problematic assets will remain very large and costly, and will jeopardise the efficient reallocation of financial resources available on banks’ balance sheets. The distribution of NPLs has been highly unequal among Portuguese banks with non-performing exposure ratios ranging from below 5 % to over 30 %. Close to ¾ of the total non-performing loan stock and 70 % of the corporate NPLs are held by the six largest banks in the system at the end of 2015 with a very high concentration of corporate bad debts (over 60 % of the total exposure) among just two lenders in the system. The coverage of NPLs has been steadily increasing reflecting the significant build-up of impairment flows. The accumulated credit impairments on the aggregate balance sheet of the banking sector represented about 9.1 % of gross credit granted to the resident private sector at the end of June 2016. However, banks differ in terms of accumulated impairments on NPL: at end-Q3 2016, the average coverage ratio for corporate NPLs was close to 80 % and ranged from 50 % to 95 %. Although some actions have been taken recently to address the large stock of nonperforming loans, there is no comprehensive strategy with clear deadlines. Early warning systems for viable firms have been improved and a task force set up to tackle the core problem. It was decided recently, for tax purposes to writeoffs loans that had been overdue for more than 2 years and had 100 % impairments; these writeoffs would also have to be derecognised from the banks' balance sheet. Moreover, current recapitalisations and the arrival of new shareholders in some of the large Portuguese banks may also lead to a reduction in such loans. The authorities have also presented a tripartite strategy to tackle the problem. This involves: revising the existing legal and judicial package, including provisions to streamlining and accelerating processes under PER (Special Revitalisation Process) and SIREVE (Extrajudicial Business Recovery System), expected to be implemented already in 2017; relying on the measures taken by individual banks in the form of an internal review of each nonperforming loan by the banks under the supervision of the Central Bank. This would lead to a clear assessment of the loans' viability and specific restructuring arrangements for each case. Although the granular examination of these loans is a step in the right direction, there is no timeline nor are there any obvious incentives to banks to undertake this costly process; encouraging banks to partly outsource the servicing of their nonperforming loans. Whether this would be followed by the establishment of a proper market of distressed assets, including new underlying regulation, is not clear. Overall, an overarching strategy in line with the recent proposals presented in the Single Supervisory Mechanism (SSM) nonperforming loan guidance is still missing. Banks are taking steps to improve their capital ratios through attracting some fresh equity. State owned Caixa Geral De Depositos (CGD), the largest bank in Portugal, is in the process of increasing its equity base by some EUR 5 bn in total. This is being done through a set of measures entailing the transfer of EUR 499 m of assets from Parcaixa to CGD, the conversion into equity of EUR 945 m of Cocos and two other operations planned for March 2017, namely a direct recapitalisation by the State in the amount of EUR 2.7 bn and a EUR 0.5 bn issuance of subordinated debt to private investors. Banco Commercial Portugues (BCP) Millennium, the second biggest bank in Portugal, recently raised its capital by EUR 1.3 bn in total through the issuance of shares. For the Chinese financial conglomerate Fosun, this implied an increase in its stake to 23.9 percent from the 16.7 percent they had previously offered to buy for 175 m. BCP repaid EUR 700 million CoCos to the state on 9 February. Banco Portugues de Investimento (BPI)'s main shareholder, the Spanish Caixabank, launched a takeover bid for the bank, a move that was welcome by investors following a long standing dispute with BPI second biggest shareholder (Angolan Santoro group) over BPI's subsidiary in Angola. Finally, Novo Banco's sale process has recently entered in its final phase with private equity funds leading the acquisition discussions. Additionally, virtually all banks in the system are restructuring their franchise to support earnings in parallel selling noncore assets to improve their capitalisation – these asset sales are however dependent on current market conditions and valuations. 4.2.2.Insurance sector The Portuguese insurance market is open and competitive but still under pressure from crisislegacy issues. With EUR 12.7 billion (equivalent to 7.1 % of GDP) in underwritten premiums the value of the Portuguese insurance market is about the European average. The sector consists of close to 80 insurers with the top five firms representing two thirds of the market, 11 000 employees and a countrywide distribution channel including over 23 000 brokers. The insurance business is dominated by the life insurance segment, representing about 70 % of gross premium income in the nonlife insurance sector. Compensation for the workmen is also provided, which is a line of business specific to Portugal. Portuguese insurers were heavily affected by the economic and financial crisis. The crisis created considerable volatility in the value of assets on Portuguese insurers' balance sheet and affected the insurance product mix with sales of life risk products linked to banks loans plummeting while bank lending continued to contract. The business model of the Portuguese insurance sector is based on strong links between banks and insurance companies. This means it is under pressure, mostly because of the challenging situation within the Portuguese credit institutions. Faced with crippling losses, in recent years, banks sold some of the biggest insurers in the country, representing about 40 % of the market. The recession weighed on the motor insurance while heavy competition and high unemployment plunged the once profitable workmen compensation segment into heavy losses. Life insurance was experiencing a revival prior to 2014 but 2015 and 2016 saw a strong reversal as economic uncertainty took hold and interest rate guarantees had to be reduced to levels close to zero. Implementing Solvency II is challenging in the current weak macroeconomic environment, which is also reflected in the recent EIOPA stress test results. 4.2.3.Housing market There are signs of stepbacks in the housing market reforms. The original framework aimed to make the housing market more dynamic by better balancing the rights and obligations of landlords and tenants. Over a period of five years, it phased out, the old system of openended leases in which rents were frozen and contracts could not be terminated by landlords, and provided for rents to be updated so as to achieve gradual alignment with market levels. It also introduced more flexibility in the choice of contract duration, set better incentives for renovation and provided a new and fast extrajudicial eviction procedure. A law which simplified administrative procedures for renovation works was adopted as part of the same package. Concerns remain about the current Parliament's proposal to further extend the transitional period for certain categories for 10 years (more 5 years). In particular the proposal concerns "old household" (contracts before 1990), namely tenants aged 65 or over or disabled, whose household income is below a certain threshold. For "commercial lease contracts" (from before 1995), it covers microenterprises; entities of public, national or municipal interest; student republics; shops and entities of historical and cultural interest. This change, on top of those already introduced after the end of the economic adjustment programme ( ), would further weaken the original scope of the reform. All these amendments to the original frameworks will reduce and delay the full benefits of the reform, which was designed to be fully applicable from 2017, by extending the transitional period and enlarging the scope of exemptions. The requested expost assessment of the lease reform has been halted and it is impossible to know exactly how many contracts that are covered by exemptions and benefits for a transitional period. The main reason for this is that existing monitoring procedures remain limited in scope, without full interoperability between different relevant data sources (registry of buildings, utility contracts, and means testing of households). Moreover, it remains impossible to gather sound evidence on the shadow economy in the rental market in the absence of the comprehensive study on the shadow economy in that market that the Portuguese authorities committed themselves to carrying out with a view to tackling housing tax evasion and fraud more effectively. 4.2.4.Private indebtedness* Deleveraging has been proceeding slowly. At present the Portuguese private sector remains one of Europe's most indebted in relation to GDP. Within the private sector, the stock of nonconsolidated debt for all household was equivalent to 77 % of GDP in June 2016 (compared to 82 % at the end of 2014) whereas for nonfinancial corporations this was over 117 % of GDP, down by 9 pps. from the end of 2014. For both households and nonfinancial corporations, the deleveraging that took place over the last quarters was due to GDP growth and changes in inflation. The process of deleveraging was particularly difficult for microenterprises where over a third make no profits. Graph 4.2.1:Debt breakdown by sector in 20022016 Source: European Commission

Graph 4.2.2:Breakdown of yearonyear changes in debttoGDP ratios, NFCs Source: European Commission Graph 4.2.3:Breakdown of yearonyear changes in debttoGDP ratios, households Source: European Commission The authorities see several possible approaches to addressing high indebtedness. Apart from the approach to nonperforming loans discussed above, these include i) the streamlining of the procedures for debt restructuring, in particular more flexibility in the PER and SIREVE schemes and stepping up mediation and coordination among creditors, ii) creating mechanisms that facilitate the debttoequity swap within a recovery plan, iii) early warning systems for companies that are in difficulties but still viable, iv) allocating more resources to speeding up insolvency proceedings, including enforcement of collateral, and v) using new IT systems in the insolvency and liquidation procedures. The legislation for these measures is expected to enter into force by April 2017. The authorities are committed to improving the retention of profits through changes in the tax system, to allow for early and fast restructuring by facilitating outofcourt arrangements and improving creditor coordination. 4.2.5.External indebtedness* Longterm debt (other investment) mostly from the general government remains the largest component of the net international investment position (NIIP), followed by net direct investment. The overall composition is tilted towards marketable debt, rather than FDI and other equity investment, which tend to be more stable, allow for better risk sharing and facilitate the transfer of expertise. Since its peak in 2012, at 116.5 % of GDP, the Portuguese investment position (NIIP) gradually declined to 110 % still very high, in 2015, reflecting improvements in the trade balance (a compression of imports and expansion in export services, particularly tourism), the continuous though slow deleveraging of the private sector and higher income transfers from remittances further to large migration outflows. Despite this adjustment in the current account, a more sizeable adjustment would be needed to reduce the NIIP to more sustainable levels. The Commission estimates that Portugal would need to run average current account surpluses of around 1.6 % of GDP until 2025 to halve the negative NIIP (about 55 % of GDP), as compared to the 0.1 % of GDP in average current account adjustment recorded since 2013. Graph 4.2.4:Breakdown of Portugal's Net International Investment Position (NIIP) Source: European Commission Graph 4.2.5:Current account financing Source: European Commission A simulation of unfavourable macroeconomic developments shows that an adverse interest rate shock is the most important risk to the NIIP. The NIIP is particularly sensitive to domestic interest rates while a negative shock to GDP growth affects it less (Graph 4.2.6). Keeping all other relevant variables constant, larger trade deficits lead to a slower pace of adjustment. A domestic demand stimulus could thus lead to higher tradebalance deficits, if it is not matched by measures to increase productive capacity. Graph 4.2.6:NIIP sensitivity to macroeconomic shocks Source: European Commission 4.3. Labour market, education and social policies 4.3.1.Labour market and active labour market policies* In an improved labour market situation, challenges remain. Unemployment rates continued to fall in 2015 and 2016, as reported in Section 1, but are still higher than in the years before 2008 and higher than the EU average. Longterm unemployment — which accounts for over half of total unemployment — risks stabilising at a high level The government has negotiated with the social partners a midterm agreement on how to improve labour market conditions. The agreement covers topics such as labour market segmentation and collective bargaining. Graph 4.3.1:Unemployment by duration Source: European Commission Labour market segmentation remains high, weighs on the prospects of young people and has the potential to increase labour market volatility. Despite the growth of permanent contracts, labour market segmentation remains high. New entrants, in particular, are exposed to temporary and precarious contracts: 53.5 % of employees under 30 work on temporary contracts (against an EU average of 33.3 %). This adversely affects young people’s career prospects and incomes, given the wage gap between temporary and permanent workers. Such contracts are also particularly sensitive to business cycle fluctuations; youth unemployment thus reacts more strongly to recessions than unemployment in general (Hüttl 2015). The lastinfirstout workforce adjustment strategies, often adopted by firms, exacerbate this effect (Scarpetta 2012). Thus, extensive use of temporary contracts may aggravate volatility in labour markets, thereby failing to dampen economic fluctuations. Recent reforms notwithstanding, some aspects of labour law may still discourage firms from hiring permanent workers. The employment protection legislation reform implemented during the economic adjustment programme lowered severance payments in case of fair dismissals. It thereby improved employers' perception about flexibility of hiring and firing practices ( ). However, legislation on unfair dismissals was left unchanged. There is a large gap between the current high level of compensation due for dismissals deemed to be unfair and that awarded in cases of fair dismissals ( ). Moreover, a worker’s reinstatement in his or her previous job can be established in court if the dismissal is deemed unfair. This may create incentives to challenge fair dismissals in court ( ) and, coupled with inefficiencies in the judicial system, lead to uncertainty about firing costs. This may, in turn, provide incentives for companies to hire on a temporary basis (on the interaction between judicial efficiency and EPL strictness, see European Commission, 2016c). Since the recent reforms affect only new employment contracts, the full impact of the reform might take time to show results in terms of shifting the share between temporary and permanent contracts. Additional reasons for persistent segmentation include the structure of employment incentives, currently being reviewed, and the fact that labour inspections are relatively ineffective. The recent increase in ‘activation’ schemes has contributed to a recovery in employment, but some of the available schemes have created incentives to boost fixedterm employment (see below). This has prompted the Government to redesign in January 2017 its employment support programme to promote hiring on openended contracts while restricting support for temporary contracts to specific cases such as the very longterm unemployed. However the expected impact on reducing segmentation seems limited as only 15 000 people are foreseen to be covered by the programme. As regards labour inspections, the Authority for Working Conditions has launched a public competition to hire 80 additional labour inspectors. This additional capacity, together with the planned interconnection of data between the services of the labour inspectorate, Social Security and Tax Authorities should enable more effective identification of bogus selfemployment and other labour infractions.

Minimum wage increases are not aligned with inflation and average productivity developments. The government has increased the monthly minimum wage (paid 14 times a year) by 5.1 %, to EUR 557 as of 1 January 2017. This increase overcompensates for recent increases in consumer prices, which rose by 0.6 % in 2016, and average labour productivity, which remained more-or-less stable (European Commission’s 2016 winter Forecast). This adds up to a similar development in the previous year. Moreover, the minimum wage rose faster than the average compensation per employee (which rose by 1.4 % in 2016), following a trend that started in 2007 ( ). In spite of the recent significant increases in the minimum wage, average wage growth has been moderate (and sometimes negative) in recent years, pointing to a limited impact on overall cost competitiveness so far ( ) but leading to an increasing wage compression. The latter may reduce the returns to skills and therefore the incentives to invest in them. The Government is monitoring the impact of minimum wage developments, namely through quarterly reports which are published and discussed with social partners. Increases in the minimum wage can reduce inwork