EUROPEAN COMMISSION Brussels, 27.2.2019 SWD(2019) 1021 final COMMISSION STAFF WORKING DOCUMENT Country Report Portugal 2019







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 EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2019 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(2019) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the MIP in-depth review 4.Reform priorities 4.1.Public finances and taxation 4.2.Financial sector 4.3.Labour market, education and social policies 4.4. Competitiveness reforms and investment Annex A: Overview Table Annex B: Commission Debt Sustainability Analysis and fiscal risks Annex C: Standard Tables Annex D: Investment Guidance on Cohesion Policy Funding 2021-2027 for Portugal References LIST OF Tables Table 1.1:Key economic and financial indicators - Portugal Table 2.1:Assessment of 2018 CSR implementation

Table 3.1:Sensitivity analysis: current account balance and net international investment position Table 3.2:MIP assessment matrix Table 4.2.1:Financial stability indicators Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth LIST OF Graphs Graph 1.1: Contributions to real GDP growth Graph 1.2: Contributions to potential growth Graph 1.3: GDP per capita in PPP Graph 1.4: Regional Convergence in Portugal Graph 1.5: Nominal compensation growth: actual and predicted based on economic fundamentals Graph 1.6: Current Account and Net International Investment Position Graph 1.7: Return on equity (%), domestic banks Graph 2.1: Overall multiannual implementation of 20112018 CSRs to date Graph 4.1.1: General government gross debt projections under baseline and alternative nominal GDP growth and interest rate scenarios

Graph 4.1.2: General government gross debt projections under baseline and alternative fiscal consolidation scenarios Graph 4.1.3: Government expenditure by function in 2016 Graph 4.1.4: Tax revenue by economic function in 2017 Graph 4.2.1: New loans granted Graph 4.2.2: Saving with domestic banks Graph 4.2.3: Valuation gap on price/income, price/rent and fundamental model valuation Graph 4.2.4: Private sector indebtedness Graph 4.2.5: Sectoral breakdown of domestic loans to non financial corporations (NFCs) Graph 4.3.1: Annual change in the employment rate of low and medium-skilled workers (age 20-64) since Q1-2009 Graph 4.3.2: At-risk-of-poverty in Portugal and European Union (current composition), 2010 vs 2016 Graph 4.4.1: Labour productivity Graph 4.4.2: Net capital stock per person employed Graph 4.4.3: Regions in Portugal and factor endowments LIST OF Boxes Box 2.1: EU funds and programmes contribute to addressing structural challenges and fostering growth and competitiveness development in Portugal Box 4.3.1: Monitoring performance in light of the European pillar of social rights in Portugal Box 4.3.2: The 2018 Tripartite Agreement Box 4.4.1: Investment challenges and reforms in Portugal

Executive summary A positive economic performance combined with past reforms is enabling Portugal to address its structural challenges ( ). The current economic expansion has facilitated strong job creation, contributing to a sizeable reduction in unemployment. Public and private debt has also been reduced. However, they remain too high, and there has been little progress in correcting imbalances, including low productivity and high liabilities with foreign creditors. Portugal’s policies in areas such as education, skills, innovation, the business environment and access to finance are helping to address these challenges, but a sustained commitment to reform is required. Economic performance is moderating with growth expected to slacken. GDP growth is expected to slacken as the impact from the volatile international environment dampens exports and private investments. However, domestic demand is projected to remain strong in the short term helped by further improvement on the labour market and an accelerated use of EU funds. Robust job creation continues, although it was slowing down in 2018, amid moderate wage growth. Portugal continues to correct its macroeconomic imbalances. Although all main indicators are moving in the right direction, public and private sector debt and foreign debt are still significantly above the benchmarks set. This continues to have a negative impact on the country’s external position, where the pace of adjustment is expected to slow down. The decline in non-performing loans (or ‘bad’ loans) along with the improved profitability is reducing the balance of risks in the banking sector. Imbalances in the labour market have been corrected and the main risks are now insufficient skills and low productivity. Public finances have continued improving, while strongly relying on higher revenue, declining interest expenditure and relatively low public investment. Higher revenue, lower interest expenditure and relatively low levels of public investment have contributed to further improvements in the headline and structural public deficits, while the structural balance excluding interest expenditure has remained broadly stable. The current economic expansion and favourable financing conditions allow for further reductions in the structural deficit to ensure a sustainable budgetary position over the medium term. This strengthens the case for the government to contain overall expenditure growth and use gains from windfall revenue and lower interest expenditure to reduce public debt faster. Higher public and private investment in innovation, upskilling, resource efficiency, transport infrastructure and modern employment policies would strengthen the long-term sustainable growth potential of Portugal. The country has one of the lowest investment rates in the EU. Insufficient maritime and railway connections make it difficult for export-oriented businesses to fully benefit from the potential of the single market. Research and development investment has recently regained strength but remains insufficient to upgrade the Portuguese national research and innovation system. Investments in resource efficiency would contribute to achieving long-term sustainable growth. The low qualification level of workers is an obstacle to investment and productivity growth. Using the full potential of the labour force also requires reinforcement of public employment services and effective active labour market policies. People’s lack of digital skills hinders their inclusion in society and their employability and reduces the potential for higher productivity. Annex D identifies key priorities for support by the European Regional Development Fund, the European Social Fund Plus and the Cohesion Fund over 2021-2027, building on the analysis of investment needs and challenges outlined in this report. Portugal has made some ( ) progress in addressing the 2018 country specific recommendations. There has been some progress in the following areas. ·Promoting an environment conducive to hiring on permanent contracts, including by reviewing the legal framework in consultation with employers and trade unions. ·Increasing the skills level of the adult population, as well as the number of people in higher education. ·Increasing the efficiency of insolvency and recovery proceedings, reducing impediments to the secondary market for the resale of non-performing loans, and improving access to finance for businesses. ·Improving the efficiency of administrative courts and reducing administrative burden. There has been limited progress in the following areas. ·Strengthening expenditure control, cost effectiveness and adequate budgeting in the health sector. Improving the financial sustainability of state-owned enterprises, in particular by increasing their overall net income and reducing their debt. There has been no progress in the following area. ·Removing persistent regulatory restrictions by ensuring a proper implementation of the framework law for highly regulated professions. Regarding progress in reaching the national targets under the Europe 2020 strategy, Portugal is making good progress in reaching its targets for renewable energy and greenhouse gas reduction. There has been significant progress in raising the employment rate, which currently stands above the target of 75 %. Further progress was made in 2017 in lowering the school drop-out rate (“early school leaving”) but is still above the target of 10 %. Significant challenges remain to achieve the targets for research and development investment, higher education attainment and poverty reduction. The Social Scoreboard accompanying the European Pillar of Social Rights highlights some challenges for Portugal. While the recent labour market performance marked a significant improvement in employment and unemployment rates, income inequality remains high and the effectiveness of social transfers (other than pensions) in reducing poverty remains limited. Moreover, despite a recent improvement, the high proportion of early leavers from education and training points to challenges in education. On the positive side, Portugal continues to have one of the highest rates of participation in formal childcare for children under 3 years old, although with a decrease in 2017, and it is still difficult to find childcare in some areas of the country. The main findings of the in-depth review contained in this report and the related policy challenges are as follows:

·External adjustment remains insufficient. The correction of flow imbalances has been partially based on cyclical factors. The recent reversal in the current account points to a slowdown in external adjustment. A more substantial adjustment could be achieved through gains in competitiveness, benefitting both the current account balance and GDP growth. ·The country’s high public debt has started to decrease, and further growth-friendly fiscal consolidation would help to keep it steadily declining. The ratio of public debt to GDP started decreasing in 2017 and is projected to decline further between 2018 and 2020, albeit at a slower pace. Continued fiscal consolidation and progress with growth-enhancing structural reforms are key to strengthening Portugal’s fiscal sustainability. It therefore remains essential to ensure adequate budgeting and effective spending control across all government sectors, in combination with decisive measures to tackle the persistently high hospital arrears and improve the financial sustainability of state-owned enterprises and the pension system. This could be complemented by a clear top-down focus on containing overall spending and deploying a comprehensive strategy for medium-term public administration reform, while making the tax system and public expenditure more growth-friendly. ·Private debt is steadily going down but still remains too high. Household and corporate debt ratios are declining but are still beyond the estimated country-specific prudential thresholds and are weighing on investments and potential growth. However, the exposure to risk is mainly in the corporate sector, which still accounts for the largest share of non-performing loans. ·Portuguese banks have steadily reduced their stock of non-performing loans while keeping their capital broadly stable. Banks’ profitability has also improved, which mainly reflects lower impairments. All major banks in the system have now accessed the secondary market for non-performing loans and are managing their stock of bad assets actively. However, the quality of assets is still low compared to those of banks in other Member States of the euro area. Therefore, it is essential Portugal continues its efforts to reform the insolvency framework and tackle various other legal bottlenecks to deal with non-performing loans. ·Strong job creation has led to a significant improvement in employment indicators. The labour market continued to improve during 2018, though at a decelerating pace. The unemployment rate dropped below 7 % in the fourth quarter of 2018, well below the euro area average, and in line with pre-crisis levels. Long-term unemployment decreased to 3 % and it is now close to the EU average (2.9 %). Youth unemployment is also declining, but is still sizeable compared to the EU average. On the back of these trends, the number of people looking for work has shrunk, while remaining sizeable, and there are indications of labour supply shortages in certain market segments. Yet, there is room to get more people into the labour market, especially in view of pronounced population ageing. ·Low worker productivity is a key challenge for improving competitiveness and potential growth. Worker productivity is still restrained by insufficient investment and structural rigidities in the product and labour markets, including a high share of low-skill employees and labour market segmentation. A significant proportion of small businesses is having difficulties growing, in part due to the heavy regulatory and taxation footprint and difficulties in accessing finance and capital. On the positive side, there are signs that credit and investment are increasingly being channelled to specific sectors, especially tradable sectors where there is a greater potential for growth and higher productivity. Other key structural issues analysed in this report, which point to particular challenges for Portugal’s economy, are the following: ·Amidst a favourable economic cycle, increases in the minimum wage do not seem to have hampered job creation among low-skill individuals so far. The minimum wage was raised to EUR 580 in 2018 and again to EUR 600 in 2019. During 2018, employment creation has been strong also among low-skilled workers, although overall job creation has decelerated. The minimum wage is now among the highest in the EU relative to the national median wage. The resulting narrowing in the differences in wages deserves monitoring, as it decreases the education premium, i.e. the difference in earnings between the more and the less highly educated, and therefore potentially reduces the incentive to upgrade lower skill levels. ·An improved labour market has not helped to tackle the high share of temporary contracts, although new measures are on the table to reduce it. A tripartite agreement was reached in June 2018 to reduce labour market segmentation through an action plan to tackle precariousness and promote collective bargaining. However, measures have not been legislated yet. While strictly limiting fixed-terms contracts can help to reduce labour market segmentation, there is a risk that such contracts negatively affect investment and job creation, particularly in seasonal sectors, such as tourism-related services. Boosting the capacity of the labour inspectorate may help to tackle the misuse of temporary contracts by employers. ·Poverty and inequality continue to improve on the back of an improving labour market. With improved labour conditions, the share of people at risk of poverty or social exclusion decreased in 2017 and is now below pre-crisis levels. However, the rate of poverty among those who are in work remains above the EU average. With the exception of pensions, social transfers are not effective in lifting people out of poverty. The improved labour market also seems to be behind the mild improvement in income inequality, which remains significantly above the EU average. ·Various programmes are aiming to upgrade education and skills. The Portuguese workforce has low qualifications. Digital skills are a particular challenge, with 50 % of the Portuguese population lacking basic digital skills compared to an EU average of 43 % (European Commission, Digital Scoreboard). Early school leaving decreased in 2017, but is still above the EU average. Progress in these areas follows from policies that have improved the vocational, educational and training system, launched programmes to enhance digital skills, and introduced measures to increase higher education enrolment. While the share of higher education graduates is increasing overall (from a low level), the number of graduates in information and communication technologies remains low. ·Less administrative burden and greater judicial efficiency are improving the business environment, while regulatory restrictions are still holding back competition. The SIMPLEX+ programme is Portugal’s main policy tool to help reduce administrative burden, but is not as efficient in addressing barriers in specific sectors, particularly when it comes to licensing. Regulations are restricting some professional business services more than the EU average and are a significant barrier to competition. Various measures are in place to improve judicial efficiency. Overall, the justice system is becoming more efficient but is facing critical challenges with disposition time (i.e. the time it takes to hand down a decision) and the backlog of cases, which are both too high. Shortcomings in planning and monitoring of public procurement hinder competition. ·Bottlenecks in the innovation system are affecting Portugal’s productive specialisation and hindering structural change. After various years of decline, the share of research and development expenditure over GDP increased recently. In parallel, some export sectors have been able to increase their technology intensity and policy support to start-ups is improving. Nonetheless, Portugal remains specialised in low and medium-low technology sectors, with multiple challenges constraining its ability to tap into knowledge-intensive sectors. Insufficient links between academia and business hinder the effectiveness of the innovation system. Policies are being deployed to improve the working conditions and employability of scientific professionals, promote investment in intangible assets, and raise digital skills. ·Energy prices in Portugal are above the EU average and there is room for greater investment and better internal and external connectivity of the Iberian Peninsula. Energy prices in Portugal are above the EU average, mainly due to the relatively high level of taxation. Further cooperation with Spain and France is fundamental for developing key energy infrastructure projects. The transport infrastructure’s development would benefit from higher investment in maritime port infrastructure, and greater integration of the railway system with Spain. 1. Economic situation and outlook GDP growth GDP growth slowed to 2.1 % in the third quarter of 2018 mainly due to weaker external demand. Household consumption growth in the third quarter of 2018 eased to 2.3 % year-on-year in line with some moderation in job creation and consumer credit growth. A significant deceleration in durable goods consumption indicates a normalization path in private consumption developments. Gross fixed capital formation growth accelerated slightly to 4.3 % year-on-year in the third quarter of 2018, driven by stronger equipment purchases, while construction investment remains weak. As broadly expected, external trade growth continues to lose momentum, particularly in terms of services, leading to a negative net external trade contribution to growth. According to the Commission latest forecast, economic growth is estimated to moderate further in the fourth quarter of 2018, mainly reflecting the slowdown in external demand and full-year growth is projected at 2.1 %. Graph 1.1:Contributions to real GDP growth Source: Eurostat The moderate slowdown is forecast to continue over the medium term driven by lower external trade and higher uncertainty. The slowdown in job creation points to some further deceleration in household spending, which would be only partly offset by moderate increase in wage growth. The household savings rate, which deteriorated in the second quarter of 2018 reflecting improvements in the financial situation and still very low interest rates, is expected to stabilise in 2019 and 2020. Private consumption growth is therefore forecast to weaken to 2.0 % and 1.8 % in 2019 and 2020. Investment is set to rebound somewhat in 2019, as the implementation of certain projects supported by EU structural funds scheduled for 2018 was postponed. Net external trade is expected to increase its negative contribution to growth in 2019, reflecting weaker export demand and solid import growth in line with still robust domestic demand evolution. GDP growth is expected to stabilise at 1.7 % in both 2019 and 2020. The trend reflects a move towards the estimated potential growth and negative impacts from the less dynamic external environment on exports. Risks to growth appear on the downside, as the increased global uncertainty could have a negative spill-over effect on business investment decisions. Export growth slows but its share in GDP continues rising. The positive cycle in tourism and the automotive industry expansion kept exports growing above global trade volumes, leading to an increase in Portugal's global market share between 2015 and 2017, forecast to continue also in 2018. However, export growth is expected to weaken with the maturing of the cycle and the deterioration in the global outlook. The growth pattern in tourism is also expected to change somewhat as the number of overnight stays is stabilising while travel revenues remain dynamic.

Potential growth Potential growth converges towards the euro area average. The strong economic performance in the country over the past years has been partly driven by the economic cycle but potential growth has also improved significantly. According to the Commission 2018 autumn forecast, potential growth is already identical to the EU average at 1.6 % in 2018 and 1.7 % in 2019. This indicates a significant improvement from the trough of -1.3 % in 2012. The positive economic development over the past years has stabilised the country's per capita income relative to the EU average in the range of 77-78 % but is still insufficient to bring a noticeable convergence. The medium-term outlook, based on potential growth estimates, shows that the income gap is likely to remain broadly stable unless a further structural improvement is achieved. Job creation turns into a major contributor to potential growth. Since 2014, employment growth has generated the largest contribution to output and its importance has been particularly strong since 2016 (see Graph 1.2). Total factor productivity has also contributed substantially, but less so in 2017 and 2018. High public and private debt, including a large share of non-performing loans, have constrained the contribution of capital accumulation, which has moved from negative values by 2017 to neutral in 2018 and is estimated to be only slightly positive over the forecast period. The extent of further deleveraging is thus set to remain an important limiting factor to growth in the medium term along with the more negative demographic situation in Portugal relative to the EU average. While employment growth has been quite strong recently, the deterioration in demographic trends is already weakening the prospects of improving potential growth through job creation. This is further raising the importance of increasing labour productivity in order to bridge the income gaps vis-à-vis more advanced Member States. Graph 1.2:Contributions to potential growth Source: European Commission Regional disparities Portugal has diverged from the EU average in terms of GDP per capita over the last 10 years. During the years before the crisis, the GDP per head in Purchasing Power Standards has fluctuated slightly above 80 % of the EU average but declined after bottoming down at 75 % in 2012. Since 2013, data show a slight rebound, however insufficient to recover the ground lost, as Portugal was at 76.7 % of the EU average in 2017, nearly five percentage points lower than the pre-crisis period of 82 % in average. Thus, in terms of per-capita-income Portugal is still a long way off (see Graph 1.3) and has not improved over the last two decades, in particular compared to the Baltics or the Visegrád countries. Graph 1.3:GDP per capita in PPP Source: Eurostat GDP per capita ranges from 102 % of the EU average in Lisbon to 65 % in the Norte region. At a lower level of disaggregation (Nomenclature of Territorial Units for Statistics III), differences are higher, ranging from 109 % of Alentejo Litoral to 48.5 % of Tamega and Sousa. Overall, the regional differentiation is more pronounced between the capital region and the rest of the country, and between the coast and the interior of the country. Despite a slow recovery since 2013, investment levels in Portugal remain low in all regions. When considering the period 20092016, the highest decline was registered in the Autonomous Region of Madeira (-58 %) while the region Norte, standing out in terms of the openness of its economy, and the capital region, have witnessed a decline of investment more limited than the rest of the country. Graph 1.4:Regional Convergence in Portugal Source: Eurostat, European Commission Inflation Despite the increase in energy prices, inflation remains low. Inflation experienced significant volatility on monthly basis in 2018 driven by accommodation prices and a significant rebound in energy prices. Nevertheless, the year-average inflation remained low at 1.2 % and is projected to increase only marginally to 1.6 % by 2020. Core inflation stood below the headline rate in 2018 but is expected to increase at a slightly faster pace over the forecast period, as service prices are expected to pick up in line with more dynamic wage developments. Following a two-year period of acceleration, house prices moderated somewhat from an annualised growth rate of 12.2 % in Q12018 to 11.2 % in Q22018 and 8.5 % in Q32018. This follows an annual average growth of 9.2 % in 2017. The recent statistics on construction volumes, along with the slowdown in tourism, indicate that supply of real estate properties is likely to gradually catch up with demand. Labour market Strong job creation continues, accompanied by a significant fall in unemployment. Unemployment rate level kept declining to an annual average of 7 % in 2018, a rate not observed since 2003. Employment growth has been rapid, with an annual rate of more than 3 % in 2017 (doubling the average growth rate observed between 2014 and 2016) and decelerated to 2.1 % in the year to the third quarter of 2018. Unemployment has consistently fallen faster than expected based on observed economic growth (European Commission, 2018a), pointing to a particularly job rich recovery, while regional disparities are limited. Meanwhile, the activity rate has been inching up since the start of the recovery reaching 81 % in the third quarter of 2018. As a reflection of labour market improvements, migration inflows surpassed outflows for the first time since 2010. Nonetheless ageing population and low birth rates represent a challenge for the labour market in the medium to long term (see Section 4.3.1). Many permanent jobs were created, but the share of temporary contracts held steady. Job creation continued both for permanent and temporary contracts in 2017 and 2018. Despite the creation of about 78 000 permanent jobs during the year to the third quarter of 2018 (age 20-64), the share of workers with temporary contracts decreased only by 0.1 percentage points from 2016 to reach 21.6 % in Q3-2018, still among the highest in the EU. Meanwhile, the share of self-employed workers (without employees) in total employment continued decreasing (to 10.7 % in 2017, against 14.9 % in 2012). Wages are expected to grow at a rate of about 2 % in 2018 and 2019. After years of moderation, nominal compensation growth returned to a pace close to 2 % in 2016 and kept steady since. According to the European Commission's Autumn Forecast, the growth rate of nominal compensation per employee is expected to be 1.8 % in 2018 and 2.1 % in 2019. This wage growth is still slower than what could be expected based on the historical relationship between nominal compensation growth and inflation, productivity and unemployment in the EU (see Graph 1.5). At the same time, it implies a slight appreciation of the real effective exchange rate (based on unit labour costs), an indicator of external cost competitiveness. There are many reasons behind the appreciation, including low productivity growth, wage moderation in other euro area Member States, as well as a relatively strong euro. Graph 1.5:Nominal compensation growth: actual and predicted based on economic fundamentals Source: Eurostat, European Commission Social developments Poverty and social exclusion indicators continue to improve on the back of the employment recovery. The at-risk-of-poverty or social exclusion rate has decreased from 25.1 % in 2016 to 23.3 % in 2017, more than 4 percentage points below the peak reached in 2014 and below pre-crisis levels. This is related to a drop in the share of severely materially deprived people and in the percentage of people living in low work intensity households (now below the EU average). The at-risk-of poverty rate (a measure of relative poverty) is also decreasing, from 19 % to 18.3 % thanks to improving income conditions of people at the bottom of the earnings distribution. National data point to a continuing fall in both rates in 2018 (income year 2017), respectively to 21.6 % and 17.3 %; an improvement in the latter is also suggested by Eurostat flash estimates ( ). Still, improved labour market conditions are not leading to a significant reduction in the in-work poverty risk which only declined by 0.1 percentage points to 10.8 % in 2017 (against an EU average of 9.6 %; more details in Section 4.3.2). The effectiveness of social transfers (except pensions) in lifting people out of monetary poverty remains low (see Section 4.3.2). Income inequality has been declining in recent years but remains above the EU average. In 2017, the ratio of incomes earned by the top 20 % to the bottom 20 % of the income distribution (the S80 / S20 ratio or income quintile ratio, measured after taxes and transfers) decreased from 5.9 to 5.7, down from a peak of 6.2 in 2014, but significantly higher than the EU average of 5.1. The recent improvement was mostly driven by an increase in the share of income earned by the lowest part of the distribution, possibly related to improving labour market conditions, the impact of recent minimum wage increases on lower incomes and improved adequacy of some benefits. At the same time, the Gini coefficient ( ) slightly decreased from 33.9 in 2016 to 33.5 in 2017, and is now below pre-crisis levels but above the EU average (30.3). Wealth indicators (e.g. the Gini coefficient of net wealth or the share of net wealth owned by the wealthiest 10 % households, as measured by European Central Bank) are close to the euro area average. External position and competitiveness

The country's net international investment position (NIIP) ( ) remains a significant source of vulnerability. At 104.9 % of GDP at the end of 2017, it is one of the largest in the EU and goes beyond the estimated prudential and fundamentally-explained thresholds, which stand at 48 % and 26 % ( ) respectively. At the same time, the current account is projected below the estimated benchmark of 2.4 % for closing the gap to the net international investment position prudential level over a 10-year ( ). On the positive side, the structure of the net international investment position has improved at a faster rate over the past years due to increased inflows of foreign direct investment. The net international investment position excluding non-defaultable instruments is estimated at -60.9 % of GDP at end-2017, improving from -66.5 % a year earlier. The ratio of net external debt to GDP is also improving but remains high. Graph 1.6:Current Account and Net International Investment Position Source: Eurostat The current account is expected to deteriorate over the medium term. It is projected to move from a slightly positive balance in past years to a neutral level in 2018 and slightly negative in 2019-2020, mainly reflecting deterioration in the balance of goods and a slowdown in tourism. In 2018, oil prices have also adversely affected the terms of trade and the nominal balance of trade. The projected increase in absorption of EU structural funds and lower interest cost for domestic borrowers should only partially offset the negative evolution of other factors. As regards competitiveness, Portuguese exporters are forecast to gain market shares in 2018 helped by the still strong nominal revenues in tourism and the capacity expansion in the automotive sector. However, exports are projected to perform broadly in line with external demand over the medium term (see Section 4.4). The weak dynamics in labour productivity weighs negatively on unit labour costs. However, pressure on cost competiveness remains modest as unit labour cost continue to move broadly in line with trading partners due to sustained modest wage developments. As regards non-cost indicators on competitiveness, Portugal has continued to gain market shares over the past years. This improvement is observed for both goods and services and is explained by cyclical and structural factors (see Section 4.4). Financial sector Financial sector performance is improving but vulnerabilities are still in place. Portuguese banks have steadily reduced their stocks of non-performing loans. This has been helped by increased investor interest, favourable economic conditions and higher property prices. Banks’ profitability also improved in the first half of 2018. These trends are set to continue but the main indicators on asset quality and capital adequacy are still weak compared to the aggregated balance sheets of the euro area. In addition, there are still legal bottlenecks in the insolvency framework and the legacy of non-performing loans is still weighing negatively on lending conditions. (see Sections 3 and 4.2). Graph 1.7:Return on equity (%), domestic banks Source: European Central Bank Private indebtedness Private debt has declined over recent years and the outlook remains favourable. In consolidated terms, the private debt-to-GDP ratio has fallen steadily from its peak of 210.3 % at the end of 2012 to 162.2 % at the end of 2017, declining in both the corporate and the household sectors. Data for 2018 confirm that the process of deleveraging continues albeit at a slower pace. Yet, debt ratios remain above the estimated country specific prudential and fundamental thresholds. For households, the debt ratio dropped to 69 % of GDP at the end of 2017 relative to prudential and fundamental levels estimated at 38 % each. For corporates, the debt ratio dropped to 93 % of GDP relative to prudential and fundamental benchmarks of 57 % and 66 % respectively. Public finances Public finances are benefiting from higher revenue on the back of strong domestic demand and favourable labour market conditions, as well as from decreasing interest expenditure. The general government headline deficit is projected to have decreased from 3.0 % in 2017 (0.9 % of GDP net of one-offs ( )) to 0.7 % of GDP in 2018 (0.3 % of GDP net of one-offs ( )) according to the Commission’s 2018 Autumn Forecast, mainly due to higher cyclical-related revenue, decreasing interest expenditure and lower-than-budgeted public investment. The structural balance is projected to have improved by around 0.3 % of GDP to -0.9 % of GDP, reflecting the corresponding decline in interest expenditure, while the structural primary balance is projected to have remained unchanged at 2.5 % of GDP. In 2019 and 2020, the general government headline deficit net of one-offs and the structural deficit are expected to remain broadly stable in the absence of further fiscal consolidation. According to the Commission’s 2018 Autumn Forecast, the headline deficit is projected to decrease only slightly to 0.6 % of GDP in 2019 (0.2 % of GDP net of one-offs), as higher cyclical-related revenue, higher property income and lower interest expenditure are used to compensate for increases in primary expenditure and reductions in tax revenue. The structural balance is accordingly also projected to remain broadly stable in 2019 (at -0.9 % of GDP), while the structural primary balance is set to slightly deteriorate (to 2.4 % of GDP). Under the forecast’s no-policy-change assumption, absent any new one-off impact, the headline deficit is set to go down slightly to 0.2 % of GDP in 2020, while the structural balance is set to remain broadly unchanged. Risks to the fiscal outlook are tilted to the downside and are linked to uncertainties surrounding the macroeconomic outlook and the potential deficit-increasing impact of bank support measures. The debt-to-GDP ratio is projected to continue its gradual decrease, albeit at a decelerating pace. After falling by 4.5 percentage points to 124.8 % in 2017, the general government gross debt-to-GDP ratio is forecast to further decline to 121.5 % in 2018, 119.2 % in 2019 and 116.8 % in 2020, mainly due to primary budget surpluses and the impact of nominal GDP growth. While expected to have still exceeded more than 3 percentage points in 2018, the decrease in the debt ratio is set to decelerate to around 2 percentage points in 2019 and 2020 mostly due to higher stock-flow adjustments. Table 1.1:Key economic and financial indicators - Portugal Source: Eurostat and ECB as of 31-1-2019, where available; European Commission for forecast figures (Winter forecast 2019 for real GDP and HICP, Autumn forecast 2018 otherwise) 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 66 % of all country-specific recommendations (CSRs) addressed to Portugal have recorded at least ‘some progress’ (). 34 % of the country-specific recommendations recorded 'limited' or 'no progress' (see Graph 2.1). Most progress was observed for CSRs associated to challenges in the labour market, education and social policies, the financial sector, and the business environment. Progress with regard to challenges related to fiscal-structural issues has been more limited. In all, further effort is warranted to effectively tackle these challenges. Over recent years, Portugal has made limited progress in addressing fiscal-structural challenges. Portugal started a bottom-up efficiency-enhancing spending review in 2016 that has been progressively broadened to cover additional policy areas. The entry into force of the new accrual-based public accounting framework and of the 2015 Budget Framework Law have however witnessed repeated delays, with full effective implementation having been postponed to January 2019 and April 2020, respectively. Although efforts were made to improve the financial sustainability of state-owned enterprises, the objective of achieving an overall net income close to equilibrium has been moved forward by one year to 2019. While past reforms had improved the long-term sustainability of the pension system, recent balance-deteriorating initiatives and the growing pressure from the ageing population would point to the need for compensatory balance-improving measures of a structural nature to strengthen the overall sustainability of the pension system. Despite steady efficiency-improving efforts in the health sector, hospital arrears continue to pose a substantial challenge. A new programme for 2019 aiming to address the underlying causes of persistent hospital arrears represents a promising first step in the right direction. Finally, progress has been made towards improving tax compliance and making tax collection more efficient. Over the past years Portugal improved debt restructuring mechanisms and reduced the debt bias. The high private indebtedness and large share of non-performing loans accumulated during the crisis increased the need for debt restructuring mechanisms. These have been put in place allowing viable firms to engage in restructuring processes at an early stage. In order to provide incentives for firms to use more capital financing Portugal has also reduced the debt bias in taxation. Measures have also been taken to improve the sustainability of stateowned enterprises but their indebtedness remains high. The vocational educational and training system has a wider offer and active labour market policies improved. In a context of low-skilled adult population, Portugal provided more vocational training opportunities to different educational levels and is achieving an increased share of employability for these graduates. In order to tackle youth and long-term unemployment, active labour market policies are improving in terms of outreach and engagement while public employment services upgraded coordination with social services. Nevertheless, effectiveness is still an issue when comparing with EU Member States and requires monitoring.

Portugal has adopted measures to improve the business environment, as well as the efficiency of network industries. Various measures have been effective in reducing the administrative burden, although sector-specific procedural rules remain a significant challenge. Energy efficiency has improved on the back of measures targeting the sustainability of the energy system. There has also been progress in improving efficiency in the transport sector, particularly in railways and maritime ports. The transparency and efficiency of the judicial system has improved. Measures have been able to reduce the case backlog. Although direct awards remain sizeable, greater transparency has been achieved with regard to concessions and public private partnerships. Portugal has made some progress ( ) in addressing the 2018 country-specific recommendations. Limited progress has been made with respect to the fiscal-structural part of country-specific recommendation 1, with the government continuing to promote cost-effectiveness measures in the health sector. Yet, hospital arrears continue to pose a substantial challenge. There has also been limited progress in improving the financial sustainability of state-owned enterprises. There has been some progress in addressing country-specific recommendation 2, with Portugal promoting hiring on open-ended contracts, including by reviewing the legal framework in consultation with social partners. There has also been some progress on skills and education thanks to new policy measures (in particular to increase enrolment in higher education) and the implementation of programmes such as Qualifica and the National Adult Literacy Plan. For country-specific recommendation 3, there has been some progress on increasing the efficiency of insolvency and recovery proceedings, and for improving access to finance. With regard to the business environment, there has been some progress through simplifications for business-administration relations (such as E-government initiatives), largely through measures within the SIMPLEX+ programme. There is also some progress improving judicial efficiency. Portuguese Administrative proceedings continue, however, to be among the most lengthy in the EU. No progress has taken place removing regulatory restrictions in professional services. The Competition Authority jointly with the Organisation for Economic Cooperation and Development (OECD) presented to the government suggested reforms to lift restrictions in 13 self-regulated professions. Portugal is expected to follow up such recommendations but at this stage no clear timeline is set. Graph 2.1:Overall multiannual implementation of 20112018 CSRs to date Source: European Commission Table 2.1:Assessment of 2018 CSR implementation Source: European Commission Box 2.1: EU funds and programmes contribute to addressing structural challenges and fostering growth and competitiveness development in Portugal Portugal is one of the largest beneficiaries of EU funds. Financial allocation from European Structural and Investment Funds aimed to support Portugal in facing development challenges, amount to up to EUR 25.9 billion in the current multiannual financial framework, potentially representing around 1.9 % of GDP annually. By the end of 2018, some EUR 21.1 billion had already been allocated to specific projects. In addition, EUR 674 million had been allocated to specific projects on transport networks, energy and digital projects, through the Connecting Europe Facility. Furthermore, numerous Portuguese research institutions and firms have benefited from other EU funding instruments, notably Horizon 2020 which provided EUR 560 million. EU funding has helped to address policy challenges identified in the 2018 CSRs. Actions financed include promoting research and innovation and synergies between academia and business; improving access to finance for small and medium-sized enterprises, stimulating entrepreneurship and innovation. This has paved the way for over 13 000 enterprises to receive support with over 1 000 receiving support to introduce new products and 600 enterprises cooperating with research institutions, favouring overall the creation of 37 000 new jobs. EU investments supported by the European Social Fund contribute to increasing the skills level, reducing early school leaving and favouring the educational attainment. The Commission can provide tailor-made technical support upon a Member State's request via the Structural Reform Support Programme to help Member States implement growth-sustaining reforms to address challenges identified in the European Semester process or other national reforms. Portugal, for example, is receiving support to develop the legal foundations and new processes for the new Budget Framework Law and to implement the new Accounting Framework. The Commission is also assisting the authorities in their efforts to improve the functioning of the inter-ministerial coordination platform, which estimates the administrative burden in the existing regulatory framework in order to promote a better regulatory framework and to reduce gold-plating of EU legislation. In addition, in 2018, work has started on designing a National Plan for Adult Literacy. Moreover, in the financial sector, support is being delivered to identify impediments to and reform priorities for enhanced access to capital markets. EU funds strengthen the administrative capacity of national, regional and local authorities and the civil society. European Structural and Investment Funds alone mobilise additional private capital by allocating about EUR 726 million in the form of loans, guarantees and equity. In addition, the European Fund for Strategic Investment has allocated EUR 2.4 billion to projects in Portugal, which is set to trigger a total of EUR 8.7 billion in additional private and public investments. Portugal ranks 3rd as to the overall volume of approved operations as a share of GDP. 25 projects involving Portugal have so far been approved under the infrastructure and innovation window of European Fund for Strategic Investment. They amount to EUR 1.2 billion in total financing, which should, in turn, generate EUR 4.3 billion in investments. Under the small and mediumsized enterprises component, 15 agreements with intermediary banks have been approved for a total of EUR 1.3 billion, which should mobilise around EUR 4.4 billion of total investment. 11 951 small and mediumsized enterprises and mid-cap companies are expected to benefit from this support. ‘Science4You’ is a notable example of such projects in Portugal. ‘Science4You’ is a Portuguese company specialised in developing and producing scientific and educational toys to improve the cognitive capacities of children. The European Investment Bank is providing the company a EUR 10 million loan to develop new products and expand its sales. https://cohesiondata.ec.europa.eu/countries/PT 3. Summary of the main findings from the MIP in-depth review

Introduction The 2019 Alert Mechanism Report concluded that a new in-depth review should be undertaken for Portugal to assess the persistence or unwinding of imbalances (European Commission, 2018b). In Spring 2018, Portugal was identified as having macroeconomic imbalances (European Commission, 2018a). The imbalances identified related in particular to external, public and private debt, banking sector vulnerabilities and weak labour productivity. This chapter summarises the findings of the analyses in the context of the MIP in-depth review that is contained in various sections in this report ( ) ( ). 3.1.Imbalances and their gravity Portugal's net international investment position remains a significant source of vulnerability. It is one of the most negative in the EU and goes beyond the estimated prudential and fundamentally-explained thresholds, which stand at 48 % and 31 %, respectively. On the positive side, the structure of the net international investment position has improved at a faster rate over the past years due to increased inflows of foreign direct investment. The ratio of net external debt to GDP is also improving but remains high. Current account developments point to a slowdown in external adjustment. The current account moved to a small surplus in 2016-2017. However, the latest estimates point to a broadly balanced performance in 2018 and small deficits thereafter. This is well below the current account value required to reach the net international investment position target over a 10-year period. The capital account is set to retain a broadly stable surplus supported by net inflows of EU transfers. Overall, the combined impact of the projected current and capital accounts suggests that the balance of external flows would bring only a very slow adjustment to the stock of external imbalances. Consequently, it is expected that the net international investment position would only reach the estimated prudential threshold by around 2030. Private debt is on a steady downward path but remains above prudential and fundamental benchmarks ( ). Both the corporate and household debt ratios are beyond the estimated country-specific prudential and fundamentals-based benchmarks. The legacy of non-performing loans remains a key weakness in the financial system. The risk exposure is mainly to the corporate sector, which accounts for two thirds of all non-performing loans. Public debt continues to exceed significantly the Treaty reference value of 60 % of GDP. However, the general government gross debt-to-GDP ratio started declining in 2017 and is set to remain on a downward path over the forecast horizon. Upgrades in credit ratings have also been contributing to more favourable financing conditions. Nevertheless, the interest burden remains one of the highest in the EU. In 2018, episodes of volatility in the European bond markets had only limited repercussions on Portuguese sovereign yields but potential contagion risks require continuous monitoring. The strong increase in job creation in 2017 and the first half of 2018 substantially improved the country's labour market performance. Headline unemployment dropped to 7 % in 2018, which is well below the euro area average and close to the EU average. Long-term and youth unemployment also decreased significantly and the labour market is not considered an imbalance or adjustment issue anymore. Low productivity continues to restrain Portugal’s growth potential. It is also negatively affecting the country’s capacity to correct stock imbalances and dampens income convergence. The weak performance is mainly explained by low labour skills and low level of investment and capital accumulation while total factor productivity has been rising over the past years. Specialisation in low value added sectors as well as the large share of small firms also weigh negatively on Portugal’s productivity rates vis-à-vis the EU average. Risks linked to the increase in house prices appear to be contained for the time being. The rebound in house prices since 2016 is seen as a correction from previously low levels of valuation and construction activity and is currently not considered an imbalance. Moreover, the stock of housing loans relative to GDP is declining and new housing loans are substantially below the rates reached before the crisis in 2008. Nevertheless, it warrants closer monitoring if the current rapid pace of real house price growth is sustained over the medium term. The increase in house prices also risks having a negative impact on the affordability of housing for socially vulnerable groups (see Section 4.3.2). 3.2.Evolution, prospects and policy responses Table 3.1:Sensitivity analysis: current account balance and net international investment position Source: European Commission Policy efforts to address external imbalances are focused on measures to support exports and improve the business environment. This includes targeted support to firms entering global markets and measures to reduce the administrative burden, increase competition in business services and regulated professions, and improve the judicial system. Some of these policies promote the adoption of digital technologies by small and mediumsized enterprises, through the Indústria 4.0 programme. Portugal is one of the least restrictive host economies to foreign direct investment and has taken tailored measures to attract this type of capital. Yet, a number of weaknesses in the administrative framework persist, including the areas of professional and transport services. Private debt has declined over recent years and the outlook remains favourable. Data for 2018 confirm that the process of deleveraging continues albeit at a slower pace driven mainly by the positive denominator impact of economic growth (see Section 4.2). Since the peak in 2012, private debt dropped from 210.3 % of GDP to 162.2 % at the end of 2017. This shows that more than 60 % of the deviation from the indicative threshold of 133 % has been corrected in this period. Overall, the pace of adjustment appears adequate. The high stock of non-performing loans remains a key weakness in the financial system but the adjustment process is advancing. The aggregate non-performing loans ratio dropped but remains among the highest in the EU and well above the EU average. Portugal is implementing a three-pillar non-performing loans reduction strategy. The reduction in non-performing loans is broadly in line with the targets in the strategy where the banks with the largest non-performing loans ratios have submitted plans for substantial reduction in bad loans by 2021. Public debt started declining in 2017 and is projected to decrease further to around 117 % of GDP by 2020. The recent upward revision of debt-increasing stock-flow adjustments and deficit-increasing one-offs, as shown in both the 2019 draft budgetary plan and the Commission’s 2018 Autumn Forecast, have made the structural adjustment needed to comply with the minimum linear structural adjustment more demanding. The Commission’s debt sustainability analysis points to a high level of sustainability risks over the medium-term (see section 4.1.1). In particular, it indicates that the debt-to-GDP ratio remains highly sensitive to shocks to nominal GDP growth, interest rates and changes to the structural primary balance as compared with the Commission’s no-policy-change baseline scenario. The public spending review in place since March 2016 is slowly being translated into implemented measures. The review was originally focused on education, healthcare, state-owned enterprises, public real estate management and centralised public procurement, and the government has since committed to add the justice and internal affairs sectors. However, hospital arrears continue to pose a substantial challenge despite recurrent capital injections, while attempts to tackle underfunding and inefficiency may only progress gradually (see section 4.1.2). The labour market continues to improve at a strong pace. Unemployment dropped to below the levels prior to the crisis. Employment growth also remained significant although slowing. The activity rate (20-64 years old) stabilised at 81 % in 2018 as the labour slack, though still relevant, declined substantially. Growing signs of labour supply shortages in some market segments put upward pressures on wages helped also by the unfreezing of career progressions in the public sector. Yet, wage growth is projected to remain moderate in the medium term along with the expected slowdown in the economic growth. Labour productivity declined slightly in 2016-2017 and was broadly stable in 2018. The weak performance is mostly cyclical due to the high rate of job creation in labour intensive sectors such as tourism-related services and residential construction in the absence of stronger capital accumulation. In the second half of 2018, labour productivity has started to improve slightly as the pace of job creation dropped slightly below GDP growth in annualised terms. Productivity is projected to gradually improve in 2019 and 2020 on expectations for a less strong and more broad-based increase in employment. Still low investment levels and some product and labour markets' rigidities are still having a negative impact on strengthening investment and productivity. The low level of qualification of the adult population also plays an important role. 3.3.Overall assessment Portugal continues to correct its macroeconomic imbalances. A major progress has been achieved in terms of labour market indicators. Strong employment growth has resulted into a drastic correction of the unemployment rate, which has fallen significantly below the euro area average, and is now in line with pre-crisis levels. Deleveraging in the private sector is advancing at an adequate, albeit slowing, pace and banks are reducing their non-preforming loans as planned. As of 2017, the public debt has also moved on a downward trend benefiting from the favourable economic conditions. The main areas of slow adjustment refer to the net external position, where the pace of improvement has weakened, and labour productivity, which remains below the EU average and is projected to increase only marginally. Productivity and potential growth remain restrained by the low level of investment, as Portugal’s share of gross fixed capital formation in GDP is among the lowest in the EU.

Stock imbalances are still high despite positive flows. Although all main indicators on the stocks of imbalances are moving in the right direction, distance to relevant benchmarks remains significant. The main vulnerabilities relate to the high stock of public debt and external liabilities. Private indebtedness is also among the highest in the EU but the underlying risks have subsided substantially. As imbalances in the labour market have been largely corrected over the past years, the main challenges are now concentrated on addressing skills and removing bottlenecks that impact investment and productivity. Policy progress differs across areas. While measures are being deployed to address hospital arrears, debt sustainability requires further budgetary consolidation and growth-enhancing structural measures. Various measures address challenges related to the administrative burden and judicial efficiency, while the progress on addressing barriers to competition is more modest. Table 3.2:MIP assessment matrix (Continued on the next page) Table (continued) Source: European Commission 4. Reform priorities 4.1.Public finances and taxation 4.1.1.DEBT SUSTAINABILITY ANALYSIS AND FISCAL RISKS* The general government gross debt-to-GDP ratio is projected to continue to go down, while remaining very high. With the last global financial crisis and economic recession that followed, very high headline deficits, the reclassification of off-balance sheet items and entities into general government and stabilising interventions in the financial system led to a steep rise in the debt-to-GDP ratio by over 30 percentage points between 2010 and 2013. After hovering around 130 % between 2014 and 2016, Portugal’s debt-to-GDP ratio posted a first substantial decline to 124.8 % in 2017, while remaining the third highest in the EU. Backed by solid primary surpluses and the favourable nominal growth-interest rate differential — whereby the combined debt-reducing effects of continued real GDP growth and inflation offset the sizeable, yet gradually diminishing, interest burden on the high debt overhang —, the debt-to-GDP ratio is expected to gradually decline from 121.5 % in 2018, to 116.8 % in 2020, under the customary no-policy-change assumption. Despite the high general government debt-to-GDP ratio, there are no significant fiscal sustainability risks in Portugal in the short term. The S0 indicator that evaluates fiscal sustainability risks in the short term, stemming from the fiscal, macro-financial or competitiveness sides of the economy is below its critical threshold (European Commission, 2019a). In particular, both the fiscal and the financial competitiveness sub-indices have values below their critical thresholds. This is confirmed by the lower and stable spreads of credit defaults swaps and a gradually improving credit rating, which allows Portuguese sovereign debt holdings to be included in wide institutional investor portfolios based on the investment grade credit assessment by all four relevant rating agencies. Having said that, Portugal is projected to face high fiscal sustainability risks in the medium term. The S1 indicator that evaluates fiscal sustainability risks in the medium term suggests that a cumulated additional improvement in the structural primary balance by 4.3 % of GDP over 5 years, compared with the Commission’s no-policy-change baseline scenario, would be required to bring the debt-to-GDP ratio down to the Treaty reference value of 60 % by 2033. This very high value for the S1 indicator is mainly due to the distance of the debt-to-GDP ratio from the Treaty reference value of 60 % (contribution of 4.1 percentage points). The Commission’s debt sustainability analysis confirms that the debt-to-GDP ratio remains at high risk in the medium term. In a debt sustainability analysis incorporating the Commission’s 2018 Autumn Forecast and other technical assumptions (see Annex B) ( ) for the medium term, the debt-to-GDP ratio is expected to gradually decline by around 1 percentage point per year and to reach approximately 107 % in 2029. Partly due to the projected unfavourable nominal growth-interest rate differential and increasing ageing costs in the projection’s outer years, the debt-to-GDP ratio is projected to remain still significantly above the Treaty reference value of 60 % (see Graph 4.1.1). Graph 4.1.1:General government gross debt projections under baseline and alternative nominal GDP growth and interest rate scenarios Source: European Commission The high debt-to-GDP ratio constitutes a long-lasting burden on Portugal’s public finances, which reduces fiscal policy’s capacity to absorb macroeconomic shocks and reduce business cycle fluctuations. The Commission's debt sustainability analysis shows that the projected moderately declining path of the debt-to-GDP ratio is sensitive to shocks to nominal GDP growth, interest rates and the structural primary balance compared with the Commission’s no-policy-change baseline scenario. Alternative scenarios incorporating plausible potential shortfalls in nominal GDP growth, sharp interest rate hikes or a less ambitious structural fiscal adjustment would actually put the debt-to-GDP ratio back on an upward path, with clear penalising effects for Portugal’s overall economic performance and potential outward negative spill-over effects via the sovereign risk channel. Without continued fiscal consolidation and with no progress on growth-enhancing structural reforms, it will be difficult to safeguard fiscal sustainability and keep the debt-to-GDP ratio on a steady downward path. The Commission’s debt sustainability analysis shows that if Portugal’s structural adjustment were consistently in full compliance with the requirements of the preventive arm of the SGP, the debt-to-GDP ratio would substantially decrease to close to 90 % by 2029, 16 percentage points below the Commission’s no-policy-change baseline scenario (see Graph 4.1.2). Conversely, if Portugal’s structural primary balance were to revert back to its historical trend (this is, to gradually converge to its last 15-year historical average at a structural primary deficit of 0.5 % of GDP), the debt-to-GDP ratio would reach as much as 126 % by 2029, 19 percentage points above the Commission’s no-policy-change baseline scenario. Against this background, the full implementation of the reformed Budget Framework Law and enhanced revenue collection could positively contribute to stronger fiscal sustainability. Moreover, renewed efforts to tackle the increasing ageing costs at their roots — this is, healthcare expenditure and pensions — could help identifying new sources of efficiency savings. Graph 4.1.2:General government gross debt projections under baseline and alternative fiscal consolidation scenarios Source: European Commission 4.1.2.Fiscal-structural issues, including pensions and healthcare* Portugal’s pension system is under continuous pressure from adverse demographic trends. The old-age dependency ratio — i.e. the proportion of people aged 65 and over relative to those between 16 and 64 — stood at 32.1 % in 2016, above the euro-area average of 29.6 % (European Commission, 2018c). Importantly, the ratio is projected to increase significantly by 35.1 percentage points, reaching 67.2 % by 2070. This implies that Portugal would go from having 3.1 working-age people for every person aged over 65 years to only 1.5 working-age people. On the other hand, steps were taken in the past to strengthen the long-term sustainability of the pension system, notably by increasing the statutory retirement age from 65 to 66 years and by linking future increases to rises in life expectancy ( ), and by restricting access to early retirement. The average effective exit age in 2017 is estimated at 64.4 years, above the euro-area’s average of 63.4 years. The duration of retirement is estimated at 18.3 years for men and 22.8 years for women, both below the euro-area’s averages of 19.3 and 23.5 years, respectively. While past reforms improved the long-term sustainability of the pension system, recent initiatives have entailed discretionary increases in pension spending. In August 2017 and August 2018, lower pensions benefitted from special increases — i.e. on top of the regular pension indexation linked to inflation and real GDP growth —, with a full-year deficit-increasing impact of around EUR 140 million. In particular, the increases were focused on those pensions that had not been updated between 2011 and 2015. Such special increases are planned to continue in January 2019, leading to an estimated deficit-increasing impact of EUR 137 million in 2019. In addition, a new special pension supplement was announced for 2019, applicable to minimum pensions that start to be paid in that year. This should lead to an estimated limited deficit-increasing impact of around EUR 26 million ( ).

Pathways to early-retirement for workers with long careers are being broadened. In October 2017, a new early retirement scheme for very long careers entered into force. It allowed early retirement without penalty for citizens aged at least 60 years who had paid contributions for at least 48 years into the social security system or into the legacy civil service pension system ( ). This early retirement scheme was broadened in October 2018 to also cover citizens who had paid contributions for at least 46 years and started when they were 16 years old or under. A further phase in the flexibilisation of early retirement started in January 2019 and is applicable to citizens who at age 60 had paid contributions for at least 40 years. The new scheme will allow them to retire early without the sustainability factor penalty but will maintain a penalty proportional to the distance in months to the legal retirement age. Beginning in January 2019, this new modality will be open to citizens aged at least 63 years and will then be extended to citizens aged at least 60 years beginning in October 2019. The authorities have estimated the associated deficit-increasing impact in 2019 at EUR 66 million. The projected surplus of the social security balance appears to mainly reflect the current economic expansion, casting doubt on its overall sustainability if the economic cycle turns. Indeed, improvements in the labour market are projected to continue translating into higher social contributions and lower unemployment-related expenditure. Nonetheless, the contributions are complemented by general transfers from the State budget and specific State transfers. related to consigned tax revenue coming from a percentage of the revenue from the value added tax, the surcharge on the real estate tax (Adicional ao Imposto Municipal sobre Imóveis) and, finally, a percentage of the revenue from the corporate income tax —– 0.5 % in 2018, rising by 0.5 percentage points per year up to 2 % in 2021. In view of the potential balance-deteriorating effect of the ongoing special pension increases, early retirement reforms and the growing pressure from the ageing population, in combination with the lack of compensatory balance-improving fiscal-structural reforms, the overall sustainability of the pension system may be at risk of not having improved in a durable manner. While healthcare expenditure in Portugal has been below the EU average, its long-term increase is expected to be among the largest in the EU. Owing to pressures from the ageing population and non-demographic determinants, healthcare expenditure is projected to increase by approximately 40 % in the long term, from 5.9 % of GDP in 2016 (below the EU average of 6.8 %) to 8.3 % of GDP in 2070 (above the EU average of 7.7 %). This expected increase by 2.4 percentage points significantly exceeds the projected increase by 0.9 percentage points for the EU as a whole (European Commission, 2018c). Importantly, the projected increase in public expenditure on healthcare due to demographic change over 2016-2070 is estimated at 2.7 percentage points of GDP, which is one of the highest in the EU. The short–term financial sustainability of the health system continues to be a concern, although progress has been made in some areas. The balance of the Portuguese National Health Service deteriorated by EUR 389 million in cash terms in 2018 compared with 2017, with expenditure growth exceeding revenue growth by 4 percentage points (Portuguese Ministry of Finance, 2018). The underlying factors for such a deterioration included a year-on-year increase in expenditure for medicines and other healthcare goods and services (including complementary means of diagnosis and therapeutic use, and material for clinical consumption) and an increase in the healthcare workforce and in the wage bill (partially related to the switch to the 35 hour working week also for private sector contracts in July 2018). Some savings have nevertheless been achieved, for instance, by relying more on centralised purchasing and making a greater use of generics and biosimilars. While there are plans to make even greater use of centralised procurement and generics in the future, the latter might be challenging, as the share of generics appears to have levelled off in recent years. The need to invest in the National Health Service remains substantial in view of the construction of new hospital centres, reinforcements in primary health care and medical equipment updates (European Observatory on Health Systems and Policies, 2018). Despite substantial clearance measures, hospital arrears continue to pose a substantial challenge. Hospital arrears stabilised at somewhat lower levels in the first half of 2018, primarily as a result of a capital injection of EUR 500 million at the end of 2017. They resumed their increase in September 2018, reaching EUR 903 million in November 2018 (compared with EUR 1 103 million in November 2017). An additional capital injection of EUR 500 million in the second half of 2018 (in addition to customary year-end clearance measures) has helped to reduce hospital arrears to EUR 484 million in December 2018 (compared with EUR 837 million in December 2017). A high stock of hospital arrears has an adverse impact on supply chain relationships, limiting the scope for cost-savings. A new programme for 2019 aims to address the underlying causes of persistent hospital arrears. It was launched in early 2018 as a joint initiative between the Ministry of Finance, the Ministry of Health and the Administração Central do Sistema de Saúde — an entity responsible for managing the financial resources of the Portuguese National Health System — to improve the sector’s overall financial sustainability. This led to recommendations for a programme to address hospital arrears, which is to move forward in 2019. The joint collaboration between these three parties is key to the programme’s ultimate success. The new programme to address hospital arrears intends to introduce a new governance model for public hospitals, coupled with a substantial increase in their annual budgets. In so doing, it aims to help identify the specific causes of arrears by differentiating, at hospital level, between inadequate budgeting and hospital management practices. The programme is to be implemented in such a way as to apply both positive and negative management incentives to increase accountability, reduce moral hazard and reward efficiency savings. According to the programme, public hospitals will be grouped into three categories based on their efficiency, measured as an average adjusted cost per patient ( ). The most efficient hospitals, in the first category, will be granted more autonomy and have their budgets increased to close the gap between budgeted funds and actual expenditure. The less efficient hospitals, in the second and third categories, will undergo increased scrutiny and receive greater policy assistance according to the magnitude of their efficiency shortfalls. They will also receive more conditional increases in funding. A total of EUR 500 million has been committed to increase hospital budgets. Although the programme represents a promising first step in the right direction, it remains to be seen whether it will lead to a sizeable slowdown in the accumulation of hospital arrears in the short term. 4.1.3.Fiscal framework and state-owned enterprises* Improving framework conditions for fiscal policy is key to achieving a growth-friendly path for structural fiscal consolidation. In this context, the full effective implementation of the Budget Framework Law — which entered into force in 2015 — remains essential. The Budget Framework Law is designed to make budget units more accountable and strengthen the medium- to long-term focus of public finances. It allowed for a three-year transitional period for applying most new features. The implementation unit of the Budget Framework Law has convened regularly, and preparatory work mostly involving IT systems set-up has been progressing, in particular for the State accounting entity project ( ). However, due to repeated delays, the entry into force of the main provisions of the revised Budget Framework Law was postponed by 1 and a half years to 1 April 2020 via the amending law 37/2018 of 7 August. Thus, only the 2021 budget is planned to be prepared under the new rules. Some elements might however become operational at an earlier stage. In terms of regulatory preparation, a series of decree-laws will require adjustment and consolidation, and the decree-law on the set-up of the new budgetary programmes will need to be prepared ( ). The full effective application of the new accrual-based public accounting framework that was last set to start in January 2018 has been rescheduled to January 2019, following delays in particular for local authorities and social security. Government expenditure with direct positive effects in long-term economic growth represents less than 20 % of total expenditure. The composition of government expenditure can be broken down into three categories: spending for the long term, welfare spending and other spending (). Empirical studies typically find that government expenditure on both human and physical capital through investment in education and infrastructure is associated with positive growth effects in the long term, while spending on other categories is usually found to have no such impact (European Commission, 2016). In Portugal, expenditure for the long term — which includes education, transport and R&D expenditure — accounted for 7.7 % of GDP in 2016, slightly below the EU average. However, while the country’s welfare spending — which includes expenditure on social protection and health – was below the EU average in 2016 (24.1 % of GDP compared with 26.6 % of GDP), Portugal deployed comparatively more resources on other spending — which mostly covers expenditure on general public services. Graph 4.1.3:Government expenditure by function in 2016 Source: European Commission A series of initiatives across the public sector aim at improving the quality of public expenditure. Many of these are included in the ongoing spending review exercise, which is expected to yield savings of EUR 236 million (around 0.1 % of GDP) across a series of public sectors in 2019. Around half of the savings is expected to come from health and education, while the other half should come from measures in the justice system and internal administration and from the growing use of centralised procurement and a shared services strategy. Having said that, concrete measures still need to be specified in sufficient detail. Furthermore, the exercise is not yet undergoing a regular and independent evaluation, in particular regarding the quantification of the savings effectively achieved. This has so far only been done for selected cases on an ad-hoc basis by the authorities. Overall, while broadening the ongoing spending review is set to have a positive effect, the resulting bottom-up savings should be complemented with a clear top-down focus on containing overall expenditure growth and deploying a comprehensive strategy for medium-term public administration reform, in combination with strengthening the growth-friendliness of public expenditure. There appears to be continued pressure to increase the number of employees and the wage bill beyond the authorities’ own budget targets. The wage bill increased by 2.1 % in cash terms in 2018, significantly above the 2018 budget target, while the average headcount of public employees rose by 1.6 % year-on-year in the year ending on 30 September 2018, with more pronounced growth in the areas of local administration, state-owned enterprises (SOEs) and education. This occurred despite the planned decrease based on the target 3:2 replacement ratio rule for 2018. At the same time, the wide-ranging programme to convert temporary contracts for permanent tasks in the public sector into permanent ones is expected to be concluded by the end of 2018 (concerning an estimated number below 20 000). The planned extension of the 35 hour week in the health sector to employees with private sector contracts (around 40 % of the workforce in the sector) has put additional pressure on the headcount and the wage bill (e.g. via extra hours compensation) since 1 July 2018. The unfreezing of career progression — which had been frozen since 2010 — has started since January 2018. The additional payments are gradually being phased in (25 % by January 2018, 50 % by September 2018, 75 % by May 2019 and 100 % by December 2019) with an estimated incremental cost of around 0.2 % of GDP in both 2018 and 2019 (and another 0.1 % of GDP in 2020 according to the 2018 stability programme). In 2019, the unfreezing of career progression will also imply performance awards (by 50 % of their amount and up to the available funding). There has been progress in local administration reforms in recent years, but employment has been growing at accelerating rates. Local and regional arrears have remained broadly stable in 2018, while the overall local and regional budgetary surplus improved in 2018. Employment in local administration increased by 4.3 % year-on-year in the year ending on 30 September 2018, around 2.5 times the growth rate observed for the general government as a whole. While the Financial Coordination Council set up in 2014 has not been convening, there have been quarterly meetings of the Regional Coordination Council. Portugal’s Directorate-General for Local Administration supported by Unidade Técnica de Acompanhamento e Monitorização do Setor Público Empresarial — a unit in the Ministry of Finance specialising in State-Owned Enterprises (SOEs) —, and the country’s Directorate-General for Budget have improved the monitoring of local SOEs and public-private partnerships. This is supported by a decree-law from July 2017 creating the obligation for local SOEs to provide direct information without going through the local authorities, while information on local publicprivate partnerships has been reported quarterly since 2016. While overall the net incomes of SOEs improved in 2017, they are expected to have remained negative on the aggregate and to vary significantly at the sectoral level. The authorities are planning net incomes of SOEs to approach as a whole a level close to, but still below, equilibrium in 2019; this corresponds to a one-year delay as compared with earlier announcements aiming at a similar outcome already in 2018. The underlying operational results have been developing very differently across SOEs, with significant improvements in the transport and financial sector in 2017, and substantial and rising deficits in the health sector. The unconsolidated debt of public non-financial corporations included in general government has fallen from 19.1 % to 17.6 % of GDP between September 2017 and 2018 (Bank of Portugal, 2019). Looking ahead, a range of measures is being envisaged to improve the monitoring of SOEs and to ensure closer adherence to their initial budgetary plans. This involves moving forward with the automatic exchange of information between SOEs and Unidade Técnica de Acompanhamento e Monitorização do Setor Público Empresarial. There are plans to introduce new incentives for employees and managers to improve reporting standards. The authorities have also indicated that SOEs that have fulfilled their purposes, that are economically unviable or that can be merged to generate savings will continue to be liquidated. Also, there are plans to prioritise improvements in the capital structure for those SOEs that have positive operational results but high levels of debt. Overall, planned rationalisation efforts and increased monitoring have still yet to translate into corrective action where needed. 4.1.4.Taxation issues, including tax administration* Tax revenue as a share of GDP has slightly increased in 2017. The overall tax revenue-to-GDP ratio, meaning the sum of revenue from taxes and net social contributions as a percentage of GDP, stood at 34.4 % in 2017, slightly higher than in 2016. Portugal’s tax revenue relies relatively heavily on consumption taxes (12.7 % of GDP in 2017, compared with 11.1% of GDP in the EU in the same year) (European Commission, 2019d). Graph 4.1.4:Tax revenue by economic function in 2017 Source: European Commission Changes in direct taxes were primarily to personal income tax in 2018, while some relatively minor further adjustments are planned for 2019. In 2018, in addition to the already planned full abolishment of the personal income tax surcharge, including for higher tax brackets, both the number of tax brackets and the value of the net income guarantee (mínimo de existência) increased. The authorities estimated that the result of these measures will be a combined loss in revenue to the general government of EUR 230 million in 2018 and EUR 156 million in 2019 (i.e. when the 2018 personal income tax statements are filled). While no major changes to general personal income tax rules have been included in the 2019 budget, a new specific temporary 5-year tax regime has been put forward for emigrants who return to live in Portugal in 2019 and 2020 ( ). The corporate income tax rate applicable to high taxable profits remains among the highest in the EU. This relative position was reinforced by the 2018 increase of the State surcharge from 7 % to 9 % for large companies, i.e. with taxable profits exceeding EUR 35 million (with additional revenue estimated at EUR 60 million), which brought the corresponding statutory corporate income tax rate to 31.5 % in 2018, significantly above the EU average of 21.9 %. Portugal’s effective average corporate income tax rate of 27.5 % in 2017 is the 4th highest among the EU Member States and compares with an effective average corporate income tax rate of around 20 % in the EU (OECD, 2018e). The budget adopted for 2019 includes some additional minor changes to the corporate income tax, notably the end of the special advanced payment (estimated revenue loss of EUR 140 million) and new tax benefits for reinvested profits and firms located in the interior of the country (around EUR 50 million as a whole). Overall, the proliferation of both size- and location-dependent preferential corporate income tax rules may put a drag on productivity and investment growth; in particular, by privileging smaller-sized firms and/or those operating in specific — possibly less productive — areas, such policies may detract businesses from scaling up and/or benefiting from agglomeration spill-over effects that could help achieve greater economies of scale and efficiency gains, while providing scope for profit-shifting within the country.

Additional changes to direct taxes in 2019 include a tax on the renewable energy sector and a new bracket in the surcharge on the real estate tax. The authorities estimate that the tax on the renewable energy sector will yield EUR 30 million in additional revenue. Furthermore, the additional bracket in the surcharge on the real estate tax introduced by the budget adopted for 2019 is also expected to yield EUR 30 million in additional revenue. The revenue from recurrent property taxes was relatively low in Portugal in 2017, representing 0.8 % of GDP (or 2.3 % of total tax revenue), compared with the EU average of 1.6 % of GDP (or 4.0 % of total tax revenue) (European Commission, 2019d). More ample changes to benefits concerning direct taxes are only planned to be decided once the dedicated working group on the evaluation of tax benefits will have presented their report (expected for March 2019). For indirect taxes, besides the new value added tax (VAT) payment scheme for imports (reverse-charge mechanism), implemented in 2018, some changes are planned for 2019. On the one hand, the budget adopted for 2019 includes rate increases for excise duties and changes to the stamp tax on credit contracts (with additional revenue estimated at EUR 75 million). On the other hand, the decrease for gasoline of the petroleum tax supplement in 2019 is estimated to generate a revenue loss of EUR 48 million. The new VAT payment scheme for imports is expected to generate some short-term revenue shortfalls from customs VAT in 2018 and 2019, which overall should be largely compensated by lower reimbursements. The budget adopted for 2019 also includes the application of the reduced VAT rate of 6 % to the contracted power in electricity and to the fixed cost of access to the gas network (estimated revenue loss of around EUR 19 million). Moreover, the 2019 budget has extended the reduced VAT rate of 6 % to electronic books, newspapers and periodicals, thereby aligning the VAT treatment of electronic and physical publications. The reduced VAT rate of 6 % will also apply to other supplies such as cultural services (estimated revenue loss of around EUR 10 million), the rental of certain medical equipment and forest cleaning. VAT collection has become significantly more efficient in recent years. The VAT gap — which provides an estimate of revenue loss due to tax fraud, evasion and avoidance, among other factors — has been steadily declining since 2011, falling by more than 5 percentage points between 2012 and 2016, from 16 % to 10 % of the VAT total tax liability (Centre for Social and Economic Research, 2018). Therefore, the VAT gap in Portugal remained visibly below the EU average of 12 %. Having said that, Portugal’s VAT policy gap — which provides an estimate of revenue loss due to the use of reduced VAT rates and exemptions —, remained high, at 51.5 % in 2016, compared to an EU average of 44.8 %. In particular, the actionable VAT policy gap — which excludes tax liability from imputed rents, public services and financial services — amounted to 19.6 % in 2016, being above the EU average of 16.5 %. The high actionable VAT policy gap is composed of the rate gap and the actionable exemption gap. Given that the actionable exemption gap is slightly below the EU average, the comparatively high actionable VAT policy gap in Portugal mostly results from the relatively high rate gap (13.9 % in Portugal, compared with 10.0 % in the EU), reflecting the use of reduced VAT rates. However, as far as inequality matters are concerned, reduced VAT rates are generally a rather poorly targeted tool to support low-income households and direct mechanisms such as income-tested cash transfers should be preferred. Environmental tax revenues rely mostly on transport-related taxes. Transport-related taxes accounted for 0.7% of GDP in 2017, compared with an EU average of 0.5% of GPD. Taxes on pollution and resources accounted for 0.02 % of GDP, compared with an EU average of 0.08 % in 2017 (European Commission, 2019d). Having said that, Portugal has relatively high subsidies for company cars (among the highest in the EU in 2015) (European Commission, 2017a). Although diesel has a higher carbon and energy content than gasoline, the applicable excise duty rates on the former have been higher than on the latter. Despite progress to address the issue over the past 4 years, Portugal still has a significantly low ratio of diesel to gasoline excises (0.71 in the country in 2018, compared with 0.81 in the EU). Overall, despite some improvements, there is scope to strengthen the growth-friendliness of the Portuguese tax system. As a result of the introduction of a Notional Interest Deduction ( ) regime (effective from 1 January 2017), the so-called debt bias ( ) in corporate taxation has decreased substantially and is now zero (Centre for European Economic Research, 2017). The same holds for family businesses that tend to have a higher share of equity-financing. This low debt-bias could in particular reward investments by young, innovative and high-risk firms that usually rely more on equity financing. The same holds for family businesses that tend to have a higher share of equity-financing. However, it remains burdensome to comply with taxes in Portugal. According to the Paying Taxes 2019 Report (World Bank, 2018a) despite ranking 34th ( ) overall as regards the ease of doing business, the time needed to pay and file taxes in Portugal remained 243 hours in 2017, the 4th longest in the EU. This is both significantly above the unweighted EU average of around 172 hours and median of around 143.3 hours. Furthermore, while Portugal offers one of the highest implicit R&D tax subsidy rate for large profitable companies in the EU (OECD, 2018f), private R&D expenditure as a percentage of GDP remains relatively low compared with the EU average. Closely monitoring and evaluating the different R&D tax measures would help better understand their effectiveness, notably in boosting investment. 4.2. Financial sector 4.2.1.Banking sector* Financial stability metrics continue to improve on the back of a favourable operating environment. Banks’ profitability increased sharply in the first half of 2018 reflecting a decreasing flow of impairments and provisions (respectively down by 30.5 % and 39 % year-on-year), a reduction in staff costs (by 7.7 %) and, to a lesser extent, an increase in income from services and commissions (up by EUR 72 million or 5.2 % year-on-year). Liquidity and funding remained at comfortable levels as deposits have gradually increased and the loan-to-deposits ratio dropped to 87.1 % in mid-2018. Asset quality improved gradually each quarter (down to 11.7 % in the second quarter of 2018 from a peak at 17.9 % in mid-2016) and the non-performing loan coverage ratio ( ) increased to 53.4 % at the end of June 2018, close to 10 percentage points higher than in June 2016. In nominal terms the progress in reducing the stock of legacy non-performing loans is substantial, at EUR 18 billion or 36 % of the original stock from the second quarter of 2016. Solvency ratios remained broadly stable with the total capital adequacy ratio at around 15 % in June 2018 and the common equity tier 1 ratio – an alternative measure of bank solvency that gauges a bank’s capital strength - at 13.4 %. The banking system’s assets began increasing again in the first half of 2018, reversing the downward trend seen in recent years, in which the total assets of the sector shrank by over a quarter after 2011. The Portuguese banks’ total assets stabilised at around EUR 400 billion - around twice the level of GDP. This compares with EUR 580 billion (345 % of GDP) in March 2012. With deposits growing slightly and loans remaining stable, the loan-to-deposit ratio fell to 89 % in June 2018- the lowest ratio since euro introduction. Consumer loans are growing rapidly, while gross mortgage lending remains subdued. Overall, loans to households increased by only 0.6 % between June 2017 and June 2018, but consumer loans grew by 11.3 %. Monthly new consumer loans amounted to less than EUR 200 million in 2012-2013, but are now at around EUR 400 million (see Graph 4.2.1). New mortgages were on average below EUR 175 million per month in 2012-2013, having fallen from EUR 1.5 billion per month in 2004-2007. Since summer 2017, they have been consistently above EUR 700 million. But despite double-digit growth in new mortgage attribution, redemptions still outweigh new housing loans. Consequently, the stock of outstanding mortgages fell by 1 %. Loans for other purposes fell by 2.4 %. Graph 4.2.1:New loans granted Source: Bank of Portugal Deposits have reached a new all-time high driven by growth in corporate deposits. Remuneration of deposits is relatively higher than in the Netherlands, Germany or Luxembourg where banks pay on average negative interest rates on their corporate deposits since early 2017. Unlike other EU-jurisdictions, Portuguese banks are forbidden by law to charge negative interest rates, even to large companies. This restriction increases the incentives for corporate savings in Portugal. Consequently, the latter has been experiencing year-on-year growth in the double digits since early 2017, pushing aggregate deposits to ever-higher record levels, while household deposits have remained stable at around EUR 140 billion since June 2016. Whereas the average interest rate for new deposits was 0.15 % in June 2018, the interest rate on the overall stock of savings was 0.22 %. This is the result of very high interest rates in 2011-2012 (see Graph 4.2.2). Graph 4.2.2:Saving with domestic banks Source: Bank of Portugal While the ratio of non-performing loans remains high, there has been a considerable reduction as the secondary market gains momentum. Portuguese banks have steadily decreased their stocks of non-performing loans and non-performing loan ratios in line with guidance from the Single Supervisory Mechanism. Lenders either work out bad debts internally, jointly through a servicing platform or increasingly put them up for sale on the secondary market. As the Portuguese property market is experiencing a strong period of growth, the secondary market for non-performing loans (often backed by real estate) is becoming increasingly competitive, with many foreign players actively looking to purchase non-performing assets. In 2017, the total value of non-performing loan secondary market transactions reached about EUR 2.3 billion. Given the strong pipeline of new deals, this figure is set to be surpassed in 2018. The aggregate non-performing loans fell by roughly one third over the last two years. It stood at 11.7 % in June 2018. The ratio of non-performing loans in the corporate segment was still very high at 22.3 % but also fell by over 5 percentage points year-on-year. Non-performing loans in the consumer loans and mortgages segments stood at 12.6 % and 4.9 %, respectively, decreasing year-on-year from 15 % and 6.5 %. Non-performing loan disposals have improved the ratios numerator while, more recently, loan growth has helped lower the ratio. In parallel, banks are focusing on the non-performing loans coverage ratio, which stood at 52.8 % in mid-2018, 9.7 percentage points above the level recorded in June 2016, when the non-performing loan ratio reached its peak. While the coverage ratio for mortgages was relatively low at 26 %, due to the importance of collaterals, it stood at 57.9 % in the segment of non-financial corporations, and 60.9 % in the consumption and other purposes segment. The Portuguese banking system is increasingly profitable, reflecting lower loan losses and past cost-cutting. Return on equity stood at 3.1 % in June 2018, improving from 0.2 % 12 months earlier. The cost-to-income ratio stood at 57.7 % in Q22018, which represents a 8.2 percentage points decline compared to March 2017 and compares well with the EU’s average of 65 %. Operational expenses decreased by 4.5 % over those 12 months. Banks are starting to reap the fruits of past cost cutting and re-sizing, and should continue adapting their systems. Operating income increased by 8.3 % over that time period, due mainly to significant impairment reduction and slightly better interest intermediation revenue based on lower deposit remuneration. Portuguese banks managed to issue shares and to attract new shareholders, yet their capital ratio is converging to the EU’s average. The system’s total capital and reserves amounted to EUR 59 billion in June 2018, compared to EUR 34.3 billion in June 2007. Between June 2017 and June 2018 the common equity tier 1 ratio increased slightly by 0.2 percentage points to 13.4 %. Since late 2016 CGD, Novo Banco, Banco Comercial Português, and Montepio strengthened their capital to the tune of EUR 4.9, 2.2, 1.63, and 0.25 billion respectively, adding close to EUR 9 billion capital to the system. Yet even after those recapitalisations, Portuguese banks are still among the EU’s least capitalised, and only the Italian and Spanish banking systems have lower overall common equity tier 1 ratios. Portuguese banks will have to further improve prof