EUROPEAN COMMISSION Brussels,7.3.2018 SWD(2018) 220 final COMMISSION STAFF WORKING DOCUMENT Country Report Portugal 2018

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

Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2018 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(2018) 120 final}





Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the Macroeconomic Imbalance Procedure in-depth review 3.1.Imbalances and their gravity 3.2.Evolution, prospects and policy responses 3.3.Overall assessment 4.Reform priorities 4.1.Public finances and taxation 4.2.Financial sector, private indebtedness and housing market 4.3.Labour market, education and social policies 4.4.Competitiveness, investment and public administration 4.5. Sectoral policies Annex A: Overview table Annex B: Macroeconomic Imbalance Procedure scoreboard Annex C: Standard tables References

LIST OF Tables Table 1.1:Key economic, financial and social indicators - Portugal Table 2.1:Summary table on 2017 CSR assessment Table 3.1:Macroeconomic Imbalance Procedure assessment matrix - Portugal 2018 Table B.1:The Macroeconomic Imbalance Procedure scoreboard for Portugal (AMR 2018) Table C.1:Financial market indicators Table C.2:Headline Social Scoreboard indicators Table C.3:Labour market, education and social 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: Activity, employment and unemployment rates (quarterly) Graph 1.4: Employment by type Graph 1.5: Labour underutilisation Graph 1.6: At-risk-of-poverty or social exclusion rate and components Graph 1.7: Current Account (CA) and Net International Investment Position (NIIP)

Graph 1.8: Return on equity (%), domestic banks Graph 1.9: Sectoral breakdown of domestic loans to nonfinancial corporations (NFCs) Graph 2.1: Overall multiannual implementation of 2014-2017 CSRs to date Graph 4.1.1: Interest rates and GDP growth shocks Graph 4.1.2: Fiscal consolidation Graph 4.2.1: Saving with domestic banks Graph 4.2.2: Valuation gap on price/income, price/rent and fundamental model valuation gaps Graph 4.2.3: Overdue loans as % of total loans by NFC's size Graph 4.2.4: Private sector indebtedness Graph 4.3.1: Employment and employment rate by educational attainment, changes between Q32014 and Q32017, age group 2064 Graph 4.3.2: Disposable income inequality before and after tax and transfers Graph 4.3.3: Early school leavers, NEET and tertiary attainment Graph 4.4.1: Labour productivity growth based on shift-share analysis % changes contributions in pps Graph 4.4.2: Labour productivity per hour worked and total factor productivity Graph 4.4.3: Labour productivity growth breakdown, (percentage changes; contributions in pps) Graph 4.4.4: FDI stocks by sectors Graph 4.4.5: Impact on labour productivity in manufacturing of tackling services restrictions 50 LIST OF Boxes Box 2.1: Tangible results delivered through EU support to structural change in Portugal

Box 4.1.1: Impact of the 2018 Personal Income Tax reform: EUROMOD based simulation of the impact of the 2018 PIT reform 27 Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights Box 4.3.2: Green Book on Labour Relations 2016 Box 4.4.1: Investment challenges and reforms in Portugal Box 4.5.1: Policy highlights: Fighting social challenges with innovation Executive summary The Portuguese economy has continued to recover both in terms of growth and employment. Economic activity has accelerated and has become more broad-based, with investment and exports picking up. Employment grew even faster than GDP, particularly in labour-intensive services while wage growth remained subdued. Imbalances are receding in the context of favourable macroeconomic and financial conditions, but public and private debt and the negative net external position remain at high levels. Challenges also remain in terms of labour productivity, the still high income inequality and labour market segmentation as well as the low level of investment. Addressing these challenges would reduce the risk of a slowdown, should the external environment and financial conditions become less supportive. ( ) Portugal's recovery has strengthened. Real GDP growth is estimated at 2.7 % in 2017, up from 1.5 % in 2016, driven by acceleration in investment and exports. Private consumption remains an important contributor to growth but is expected to slow down slightly over the medium term, and the net external trade contribution to growth is expected to become broadly neutral. GDP growth is projected to slow down to 2.2 % in 2018 and 1.9 % in 2019 as positive cyclical effects are projected to fade away and output approaches its potential. Higher revenue and lower interest rates enabled the headline deficit to be further reduced while the structural deficit remains broadly stable. The favourable economic cycle together with the decline in interest payments would allow for reductions in the structural deficit to ensure a sustainable budgetary position over the medium term. However, the currently planned structural adjustment lacks ambition. Containing expenditure growth and using gains from lower interest expenditure would help accelerate public debt reduction. Portugal has made some ( ) progress in addressing the 2017 countryspecific recommendations. In the area of public finances there was limited progress in improving the financial sustainability of state owned enterprises and in decreasing health sector arrears. Some progress can be seen in the broadening of the spending review and in the pension system. While limited progress was observed in measures to promote hiring on open-ended contracts there was some progress in activation of long-term unemployed people and on the minimum wage whose increases so far have not affected job creation. In the financial sector there was some progress in implementing a strategy addressing non-performing loans and improving access to capital. Limited progress was observed in decreasing administrative burden and tackle regulatory barriers in construction and business services. But some progress was made in improving insolvency and tax proceedings. Regarding progress in reaching the national targets under the Europe 2020 strategy, Portugal is performing well in greenhouse gas emissions reduction, renewable energy and energy efficiency targets and increasing the employment rate (73% in 2017). The early school leaving rate dropped significantly in previous years, but slightly increased in 2016 and remains well above the EU average. There are still considerable obstacles to achieving the targets on R&D investment, tertiary education attainment and poverty reduction. Portugal faces challenges with regard to a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. The high share of people at risk of poverty and social exclusion is declining, but the impact of social transfers (other than pensions) on poverty reduction is limited. Income inequality has also started to subside but remains high, in a context where household disposable income is still below pre-crisis levels. While employment keeps recovering steadily, labour market segmentation remains a serious challenge, with young people particularly affected. The level of digital skills among the adult population is also below the EU average. On the upside, Portugal does well in terms of participation of children in formal childcare and has recently taken measures to promote work-life balance. The main findings of the in-depth review contained in this report and the related policy challenges are as follows: ·The external position has been improving on the back of current account surpluses and higher nominal growth. The net international investment position was still negative at -104.7 % of GDP at the end of 2016, but is decreasing thanks to small but continuous current account surpluses and a pickup in growth. Current account surpluses will need to be sustained for an extended period of time to decisively bring down the still very high external liabilities. ·Public debt started decreasing from a high level and further fiscal consolidation would contribute to ensuring a steady decline. With no further bank recapitalisations expected, public debt is estimated to have started decreasing to reach 126.4 % of GDP in 2017. Ensuring public debt sustainability in the medium and long term hinges on a structural improvement in public finances and a sustainable budgetary consolidation. In this context, progress in broadening the spending review is set to have a positive effect, which could be larger with even more ambitious savings targets. In a similar vein, controlling expenditure, managing debt and improving the financial sustainability of state-owned enterprises are essential aspects to improve public finances. At the same time, the sustainability of the pension and health systems remains important with hospital arrears representing a particular challenge. ·Private indebtedness is decreasing at an appropriate pace linked mainly to faster economic growth though the debt stock is also decreasing in absolute values. Household and corporate debt ratios are declining but are still beyond prudent levels weighing negatively on investments and potential growth. ·The adjustment process in the Portuguese banking sector is ongoing, but challenges remain, including a declining but still high stock of non-performing loans. Portuguese banks remain among the least capitalised and have lower profits than their EU counterparts. However, capital increases together with the ongoing efforts to reduce costs and asset quality improvement are improving financial sector prospects. While falling in absolute terms, the still high proportion of non-performing loans (14.6 % in September 2017) remains a burden and a risk for banks' financial soundness. If not solved, it could be a barrier for new investments. A comprehensive strategy for a faster reduction of non-performing assets is therefore being implemented. Quicker winding-up of non-viable firms through insolvency procedures and a secondary market for non-performing loans could free credit supply for new investments and lower risks to the banking sector. ·Employment is fast increasing contributing to a decrease in total unemployment while wage pressure remains low. The labour market continued to improve strongly in 2017 benefitting from the job-rich recovery. Unemployment declined considerably from 11.2 % in 2016 to 9 % in 2017 and is now lower than the euro area average. The employment rate reached its highest level since 2008. This has not put significant pressure on wages as most of the job openings were in sectors with low-skill profiles and lower-than-average salaries. In addition, some labour market slack still persists, preventing wage growth from a significant increase. Youth and long-term unemployment remain a concern. ·Labour productivity growth remains sluggish in the medium term, limiting the potential to converge towards the EU average. While total factor productivity is estimated as a major contributor to potential growth, value added per employee dropped further in 2017 due mainly to the high number of jobs created in labour intensive sectors such as tourism-related services and residential construction. The relatively low-skill level of the labour force, small size of firms and other bottlenecks in the product and labour markets remain significant barriers to productivity increases. The low share of investment in GDP also contributed to a labour productivity slowdown.

Other key structural issues analysed in this report, which point to particular challenges for Portugal’s economy, are the following: ·Minimum wage increases have supported the incomes of low-wage workers and do not seem to negatively affect job creation. In particular, the minimum wage increases have not prevented the employment rate of low-skilled workers from rebounding during the recovery, also thanks to expansion in labour-intensive sectors such as tourism and construction. Nevertheless, risks remain concerning the employability of this segment of workers. The compression of the wage structure decreases the education premium, reducing also the incentive for workers to upgrade their skills. The Government and social partners keep monitoring the impact of minimum wage developments. ·Despite an increase in permanent hiring, the proportion of workers on temporary contracts is high. This raises doubts on the effectiveness of recent measures to tackle labour market segmentation. Hiring workers on temporary contracts is widespread with a large wage gap between temporary and permanent employees. While new measures to address segmentation are subject to discussions with social partners, no action is currently planned to review the legal framework for dismissals. ·Poverty and inequality indicators have improved further. The at-risk-of-poverty or social exclusion rate is getting closer to the EU average and the income share of the poorest 20 % increased since 2015. Despite the strong redistributive effect of the tax and benefit system, the level of income inequality is high. The effectiveness of social transfers (excluding pensions) in lifting people out of poverty is low. The adequacy of the minimum income scheme has been improved but remains limited while housing affordability is an increasing challenge for low-income households. ·Programmes are being rolled out and reforms implemented in Vocational Education and Training to upgrade the skills of the adult population. Their effectiveness in upgrading worker's basic skills (numeracy, literacy and digital) and ultimately raising productivity will depend on the coverage and quality of the training offered, going beyond the mere recognition of skills. The National Digital Competences Initiative aims to strengthen digital literacy, yet it is too early to ascertain its impact. Early school leaving has decreased significantly in the last decade, but is still above the EU average and slightly increased in 2016. Young people from a disadvantaged socioeconomic background show on average lower educational achievements. While the attainment of qualifications in tertiary education is increasing, the employability of recent graduates is below average. ·Measures to improve the business environment have been put in place, but regulatory restrictions remain in business services. New credit lines and programmes matching firms with equity investors, are improving the business environment, including SMEs access to capital. Capital financing is however limited. Administrative burden is decreasing thanks to simplification programmes. Restrictions in business services are being assessed but so far no action has been taken and regulatory barriers in professional services still restrict competition. Case backlog in courts is decreasing but time in court remains long, in particular for insolvent firms, and the system’s performance scores low compared with the EU average. Construction investment is increasing due to raising demand, but sector restrictions remain. Corruption and transparency in public procurement are still perceived by businesses as areas of concern. ·Improvements in network industries and business digitisation are visible while there is room for improvement in innovation. Key bottlenecks remain in the innovation system, such as barriers for university-business cooperation and better synergies between R&D and other intangible assets. Energy prices in Portugal and energy intensity in transport and industry sectors are high. However, market concentration is decreasing. The rail system is still underused especially the connection with Spain and some projects are facing delays. 1. Economic situation and outlook GDP growth Economic growth picked up to 2.9 % yearonyear in the first half of 2017 and moderated to 2.5 % yearonyear in the third quarter. Full-year growth is estimated at 2.7 % in 2017, driven by acceleration in investment and exports. Private consumption remains an important contributor to growth but is expected to slow down slightly over the medium term along with a marginal increase in the household saving rate, which remains well below its historical average. Strong domestic demand also keeps imports robust and therefore the net external trade contribution to growth is expected to be broadly neutral over the forecast period (Graph 1.1). Overall, GDP growth is projected to slow down somewhat in the medium term as the positive cyclical effects are projected to fade away bringing the actual output closer to its potential. Graph 1.1:Contributions to real GDP growth Source: Eurostat Investment growth rose strongly from 1.6 % in 2016 to nearly 10 % in 2017 but its share in GDP remained low at around 16 %. Following a strong increase in 2017, equipment investment is expected to ease in 2018 before picking up again in 2019. These fluctuations are largely due to the large boost from the capacity upgrade in the country’s biggest automotive company in 2017. After a strong rebound in 2017, investment in construction is set to moderate over the forecast period, as it is not expected to reach the pre-crisis level any time soon. Over the medium term, investment is expected to be driven by improved corporate profits, a modest recovery in bank lending and some acceleration in implementing EU funds (see section 4.4.2). Exports of goods and services increased substantially in 2017. The positive cycle in tourism and the automotive industry expansion are expected to keep exports growing above global trade volumes also in 2018. Export growth is however projected to be more in line with trade partners over the medium term as tailwinds from car manufacturing and tourism are likely to weaken while productivity gains are set to remain subdued. Imports are projected to grow strongly, driven by domestic demand and the large import component of the export-oriented automotive industry. Consequently, the current account is projected to retain a small surplus over the forecast period. This is also helped by a decline in the projected interest payments to non-residents, following the sovereign rating upgrades in 2017 that led to a significant drop in the government bond yields. Short and medium-term risks are broadly balanced, while long-term risks are tilted to the downside. Economic activity has increased, becoming more broad-based, with a strong pick-up in investment and exports which are expected to remain robust over the medium term. However, weak productivity growth, population ageing, limited specialisation in sectors with higher value added, relatively low labour skills, and deterioration in the capital stock might dampen potential growth perspectives (see 4.4.1). Potential growth Potential growth improved over recent years, but convergence to the EU in terms of income and productivity remains weak. Although Portugal is projected to have grown above the EU average in 2017, this is partly driven by cyclical improvements. Furthermore, the medium-term outlook, based on potential growth estimates, shows that the income gap relative to more advanced Member States is likely to remain broadly stable unless a further structural improvement is achieved. Total factor productivity and job creation support potential growth. On the other hand, despite the rebound in investment since the second half of 2016, the contribution from capital accumulation is still slightly negative in 2017 and is expected to turn only slightly positive in 2018 and 2019. Despite some recent improvements, high public and private debt, including a large share of non-performing loans, as well as regulatory barriers and structural weaknesses in product and labour markets (see Section 4) are still having a negative impact on investment and growth. Following a significant deterioration during the crisis, the labour market has improved substantially since 2014, becoming a positive contributor to potential growth (Graph 1.2). Graph 1.2:Contributions to potential growth Source: European Commission Inflation Inflation increased from 0.6 % in 2016 to 1.6 % in 2017 due mainly to the impact of energy and accommodation costs. Inflation is set to stabilise at around 1.5 % over the forecast period, reflecting moderate wage dynamics and subdued price developments in the group of non-energy industrial goods. Some upward risks to inflation arise from the impact of tourism on accommodation and other tourism-related services, particularly in off-peak periods where the growth rate in foreign tourist visits could be still significant.

Labour market In line with economic developments, the recovery of the Portuguese labour market continues. Supported by strong employment growth, unemployment dropped considerably from 11.2 % in 2016 to 9.0 % in 2017 (Graph 1.3) and the provisional monthly rate moved to 7.8 % at the end of the year. Unemployment has thus dropped to its lowest level since 2004 and is already below the euro area average. The economy added about 150,000 jobs in 2017 and employment growth reached 3.3 %, continuing to grow faster than GDP. The employment rate increased from 70.6 % in 2016 to estimated 73.0 % (age 20-64) in 2017, which is only slightly below the pre-crisis rate of 73.4 % in 2008. The recovery has reduced outward migration, but the demographic imbalance resulting from past migration might create labour supply shortages especially for high skilled workers (see Section 4.3). Over the medium term, job creation is expected to decelerate becoming more into line with GDP growth. Unemployment is set to decline further in 2018 and 2019. Graph 1.3:Activity, employment and unemployment rates (quarterly) Source: Eurostat, LFS Despite the significant labour market improvements wage growth remains moderate. Nominal wages are growing broadly in line with consumer price inflation despite the strong increase in employment. As some labour market slack( ) remains (Graph 1.5) and most job openings are in sectors with lower-than-average salaries, only a moderate wage increase is expected over the forecast period. The latter also contributed to weak labour productivity performance (see Section 4.4.1) in 2016-2017 due mainly to high job creation in labour intensive sectors such as tourism-related services and residential construction. Nominal wage growth is expected to remain moderate in 2017 and 2018 and real wages are expected to move broadly in line with productivity. It is however possible that the current positive economic cycle could build up some wage pressure over the medium term, particularly in sectors with higher demand for skilled labour. In recent years new jobs were mainly created on open-ended contracts, but temporary employment remains high. Employment growth almost exclusively consisted of permanent jobs in the first three quarters of 2017 (Graph 1.4). However, the creation of permanent jobs did not reduce the proportion of temporary employees which remained stable at 21.9 % (Q32017, age group 20-64), still one of the highest in the EU (see Section 4.3.1). In addition, the broader indicators on labour supply have not fully recovered from the crisis levels suggesting that some structural weakness in the labour market persist (Graph 1.5) (see section 4). Graph 1.4:Employment by type Source: Eurostat, LFS Graph 1.5:Labour underutilisation Source: Eurostat Social developments Poverty indicators have significantly improved in recent years on the back of stronger economic activity and employment. The at-risk-of-poverty or social exclusion rate has decreased from 26.6 % in 2015 to 25.1 %, in 2016, getting closer to the EU average of 23.5 %. This is mostly linked to a drop in the share of severely materially deprived people (from 9.6 % to 8.4 %) and in the percentage of people living in low work intensity households (from 10.9 % to 9.1 %). A further decrease to 23.3 % in 2017 (income reference year 2016) is estimated based on (preliminary) national statistics. Monetary poverty is also decreasing, although improved labour market conditions are not leading yet to a reduction in the in-work poverty risk which could be linked to the increase in overall incomes (see Section 4.3.2). On the other hand, the effectiveness of social transfers (except pensions) in lifting people out of monetary poverty is still low (see Section 4.3.2). Income inequality is improving but remains high when compared to the EU average. In 2016, the income of the richest 20 % of the population was 5.9 times that of the poorest 20 %, against an EU average of 5.1. This ratio has slightly decreased since 2015, partly reversing an upward trend between 2011 and 2014, thanks to an increase in the income share of the poorest 20 %. This is on the back of improving labour market conditions and the positive impact of minimum wage increases on lower incomes. A further decrease to 5.7 in 2017 is estimated based on (preliminary) national statistics. The rise in disposable income between 2014 and 2016 has affected all income classes, but is more significant for the lower-income groups. The S80/S20 ratio remains above its lowest level of 5.6 in 2010. In addition, health and education inequalities remain issues of concern (see Sections 4.3.2 and 4.3.3). Household disposable income is still below pre-crisis levels. While GDP improved slightly between 2010 and 2017, household income actually decreased in the same period. This shows difficulties to achieve inclusive growth in that period due to a limited trickle-down to improve families’ income. Graph 1.6:At-risk-of-poverty or social exclusion rate and components Source: Eurostat, EU-SILC External position and competitiveness Net external liabilities remain among the highest in the EU. The net international investment position (NIIP) decreased in 2015-2016 but reversed slightly at the end of September 2017. This reversal was however due to valuation effects from the higher price in government bonds held by non-residents while the net impact from the flows in the current and capital accounts were still positive. At 104.7 % of GDP, NIIP remains significantly beyond the estimated country-specific prudential threshold of 48 %( ) and the current account, at around 0.1 %, is below the estimated benchmark of 2 % for closing the gap to the NIIP prudential level over a 10-year period( ). The NIIP structure improved meanwhile due to the increased net inflow of foreign direct investment (FDI). However, net FDI still plays a small role in the NIIP while net marketable external debt accounts for 66% of GDP in 2016 (Graph 1.7), indicating a continued potential risk to external sustainability. Graph 1.7:Current Account (CA) and Net International Investment Position (NIIP) Source: Eurostat External flows are expected to continue reducing the stock of external liabilities but at a slow pace. The current account posted a small surplus in 2016 and is projected to remain only slightly positive in the medium term. Exports are gaining further importance in the economy but their impact on the current account is expected to be offset by a similar growth in imports, as investment demand is picking up from historically low levels (see Section 3). The evolution of unit labour costs is broadly in line with main trading partners. Despite past increases in the minimum wage and strong labour demand, wage developments remain contained and to a large extent offset the negative impact of the weak productivity performance on competitiveness. Overall, the latest economic developments do not indicate immediate cost pressures on competitiveness. Nevertheless, the afore-mentioned risks of a possible build-up of wage pressures over the medium run may also pose risks of a slowdown in the export-led recovery of the economy over the medium and long run, even if some upgrade of exports quality is noticeable. Non-cost competitiveness indicators developed positively over recent years, as seen from the increase in total factor productivity. Portugal's share in global exports increased by 3.5 % in 2016 and a stronger increase is projected for 2017. Exports also exceeded the growth in imports from main trading partners by 2 % in 2016 and the strong performance is projected to continue in 2018, reflecting the above-mentioned impact of tourism and car manufacturing. Financial Sector The adjustment process in the Portuguese banking sector is ongoing. Portugal still has the EU's third highest non-performing loan (NPL) ratio (after Greece and Cyprus). Profitability turned positive again in the first half of 2017. The capital ratio is one of the EU’s lowest. Return on equity improved in the first half of the 2017 but is now only slightly positive leaving the Portuguese banks still in a weak position. The system’s Tier 1 capital ratio (a measure of a bank's core equity capital to its total risk-weighted assets) stands at 13.8 % in Q2-17, still below the EU average, but already somewhat improved following the recapitalisations of the largest banks (see Sections 3 and 4.2).

Graph 1.8:Return on equity (%), domestic banks Source: European Commission Private indebtedness Private debt is on a steady downward trend since 2012 though it is still above prudent levels. In consolidated terms, the share of private debt in GDP fell to 171.4 % at end2016. This is well above the estimated prudential and fundamental thresholds, which lies in the vicinity of 78 % and 105 %, respectively ( ). Loans to tradable sectors accounted for about 53 % of total loans at the end of June 2017 and increased by 11 pps. since early 2009, reflecting the stronger deleveraging pressures in the non-tradable sectors, particularly in construction. The share of manufacturing is still quite low with 17 % of the total value of loans although credit growth to the manufacturing sector accelerated in 2017. On the other hand, this low level may also reflect the fact that manufacturing companies depend less on bank lending, as they have access to alternative sources of financing such as bonds, equity or financing through foreign-owned parent companies. The overdue loan ratio in the tradable sector remains around 10 %, which is 10 pps. below the value in the non-tradable sector in Q22017. The increasing share of loans to the tradable sector and its low rate of NPLs contributed to the reallocation of resources, which is essential for successfully rebalancing the Portuguese economy (see Section 3). Graph 1.9:Sectoral breakdown of domestic loans to nonfinancial corporations (NFCs) Source: Bank of Portugal Public Finances Public finances are benefitting from the strong recovery and substantially decreasing interest expenditure. The headline deficit is projected to have decreased from 2.0 % in 2016 to 1.4 % of GDP in 2017 according to the Commission's 2017 autumn forecast, mainly due to the accelerated economic recovery, decreasing interest expenditure and lower-than-budgeted public investment( ). As the improvement in the headline deficit is mostly cyclical in nature and supported by lower interest expenditure without being accompanied by discretionary fiscal consolidation measures, the structural balance is expected to have improved only slightly in 2017. In 2018 and 2019, the headline and structural deficit ratios are expected to remain broadly stable lacking further structural consolidation. The headline deficit is forecast to remain stable at 1.4 % of GDP in 2018 as higher recovery-related revenue and lower interest expenditure are used to compensate for increases in primary expenditure and reductions in personal income tax revenue. As the impact of discretionary measures and savings in interest expenditure is expected to be broadly neutral, the structural balance is also projected to remain broadly stable in 2018. Under the forecast's no-policy-change assumption, the headline deficit is set to reduce slightly to 1.2 % in 2019 while the structural balance is set to remain largely unchanged. The structural primary balance is forecast to deteriorate by about ½ % of GDP over the forecast horizon. Risks to the fiscal outlook are tilted to the downside, linked to uncertainties surrounding the macroeconomic outlook and the potential deficit increasing impact of banking support measures in 2017. The debt-to-GDP ratio is expected to have started falling in 2017 from very high levels. Portugal’s gross public debt-to-GDP ratio is forecast to have fallen to 126.4 % in 2017, and to further decrease to 124.1 % in 2018 and 121.1 % in 2019, due to primary budget surpluses, higher nominal GDP growth, lower interest payments and planned decreases in the cash buffer (see section 3). Table 1.1:Key economic, financial and social indicators - Portugal Source: Eurostat and ECB as of 30 Jan 2018, where available; European Commission for forecast figures (Winter forecast 2018 for real GDP and HICP, Autumn forecast 2017 otherwise) 2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Portugal in 2017( ) has to be seen in a longer term perspective since the introduction of the European Semester in 2011. Looking at the multi-annual assessment of the implementation of the Country Specific Recommendations (CSRs) since these were first adopted in 2014( ), 65 % of all the CSRs addressed to Portugal have recorded at least 'some progress' while 35 % of these CSRs recorded 'limited' or 'no progress' (see Graph 2.1). Most progress was observed for CSRs where the challenges posed to the Portuguese economy were also larger. These relate to the reform of labour contracts, some aspects of social assistance as well as reduction in private indebtedness. However, given the dimension of the remaining challenges in these areas, further work is still warranted. Graph 2.1:Overall multiannual implementation of 2014-2017 CSRs to date Source: European Commission Portugal has progressively corrected its headline deficit and made some progress in carrying out an expenditure review. Following the financial crisis, Portugal went through a period of an increasing debt-to-GDP ratio and a worsening budget balance leading to an excessive deficit. With the consolidation effort that took place during the adjustment programme and in the years after, in 2016 the deficit went below the 3 % threshold for the first time in more than a decade. In 2017, Portugal is expected to have reached a government budget deficit of 1.4 % of GDP and the debt-to-GDP ratio to start dropping after having stabilised around 130 %. In the last two years Portugal started an expenditure review that has been progressively broadened to several policy areas and in recent years has made efforts to improve the sustainability of the pension system and of the financial situation of state-owned enterprises. Some progress has also been achieved in terms of improving tax compliance. An area where sustainability challenges remain is the health sector and in particular the permanently high arrears. 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 State Owned Enterprises but their indebtedness remains high. Significant progress was made in improving the attractiveness of vocational training and the coverage of social assistance. To tackle the low skill level of the adult population in Portugal, Government authorities have significantly improved the vocational and education training system in terms of quality and coverage. In order to dampen the negative social effects of the economic crisis, Portugal broadened the coverage of social assistance including the minimum income scheme, partly reverting earlier measures going in the opposite direction. Some progress was also observed in improving the efficiency of public employment services to facilitate the activation of the unemployed. An evaluation of reforms in the employment protection system was carried out and measures were taken to increase incentives to hiring on open-ended contracts, although their impact is still not sufficient to tackle labour market segmentation. Competition authorities and cooperation between firms and universities were strengthened and the efficiency of network industries has improved. Cooperation between universities and the business sector could still be improved but measures have been taken to strengthen links. More resources have been ensured to the national regulators and the competition authority. Measures to improve the sustainability of the energy system and reduce costs have been implemented. Progress has also been made to improve efficiency in the transport sector namely in rail and ports. Some progress has been achieved in increasing transparency and improving the efficiency of the judicial system. Measures have been taken to reduce the case backlog in terms of proceedings with the number of cases being finalised higher than those entering courts. Transparency has increased in particular regarding concessions and public private partnerships even though direct awards remain high. Portugal has made some ( ) progress in addressing the 2017 countryspecific recommendations. In the area of public finances there was overall limited progress with a more positive evolution seen in the broadening of the spending review in line with euro area recommendations and ensuring pension sustainability. Limited progress was observed in promoting hiring on open-ended contracts but some progress is observed in activation of long-term unemployed and as concerns the minimum wage that in spite of recent increases has not hampered job creation. Overall some progress in the financial sector namely for addressing non-performing loans and improving access to capital. Although some simplifications have been introduced for business-administration relations (such as E-government initiatives) and new studies aimed at assessing regulatory restrictions are on-going, limited progress was observed in reforming regulations in the business and construction services sectors, as no regulatory reform has been yet put in place for the various professional business services and for the construction sector as a whole.

ESI Funds are pivotal in addressing key challenges to inclusive growth and convergence in Portugal, notably by improving the business environment via facilitating access to finance for SMEs, promoting synergies between academia and business, and stimulating entrepreneurship and innovation to favour job creation. ESI Funds also help strengthen links between vocational training and labour market needs; they help reduce early school leaving and improve coordination between social and employment services and support the provision of adequate social protection coverage. Table 2.1:Summary table on 2017 CSR assessment Source: Commission Services Member States can request from the Commission technical support to prepare, design and implement growth-enhancing structural reforms. The Structural Reform Support Service (SRSS) provides, in cooperation with the relevant Commission services, tailor-made technical support, which does not require co-financing and is provided at a Member State's request. The support addresses priorities identified in the context of the EU economic governance process (i.e., implementation of country-specific recommendations), but the scope of the SRSS support is wider as it can also cover reforms linked to other Commission priorities, or reforms undertaken at the initiative of Member States. Portugal has requested technical support from the SRSS to help implement reforms in various areas such as: revenue administration and public financial management and growth and the business environment. In particular, the SRSS provides support to help develop a framework for the new budget law and implement an accounting framework based on international public sector accounting standards. It is also providing support to improve the functioning of an inter-ministerial coordination platform and to reduce administrative burden in the national regulatory framework. Box 2.1: Tangible results delivered through EU support to structural change in Portugal Portugal is a beneficiary of significant European Structural and Investment Funds (ESI Funds) support and can receive up to EUR 25.8 billion until 2020. This represents around 2 % of GDP annually over the period 2014-2018 and 77% of public investment ( I ). By 31 December 2017, an estimated EUR 16.8 billion (65 % of the total) was allocated to projects on the ground. This has paved the way for over 8 500 enterprises to receive support with over 1 000 to introduce new products and 450 enterprises cooperating with research institutions. EU investments contribute to raising the capacity of childcare infrastructure to accommodate an additional 32 000 children, and to improve health services for more than 2.7 million people; 76 000 higher education students have benefited from grants and 17 000 adults are participating in professional education and training courses; 40 000 youngsters and 11 000 adults have been integrated in the labour market; over 3 000 people with disabilities are also receiving support to help them participate in the labour market. Over 43 000 young people have been supported; more than 29 000 young people 'Not in Education, Employment or Training' have benefited from traineeships and 14 000 from support in employment, education or training. Out of the EU financing, EUR 2.6 billion is planned to be delivered via financial instruments, which is a five-fold increase compared to the 2007-2013 period. ESI Funds help address structural policy challenges and implement country-specific recommendations. Actions financed cover promoting R&D and synergies between academia and business; improving access to finance for small and medium-sized enterprises, stimulating entrepreneurship and innovation in order to favour job creation and rebalance the economy towards a higher share of the tradable sector; improving the effectiveness of the justice system; enhancing efficiency and safety in the railways sector; supporting women's' participation in the labour market; strengthening links between vocational training and the labour market and adult learning development. ESI Funds are contributing to addressing the alignment of salaries with productivity; the reduction of early school leaving and improving the coordination between social and employment services and providing adequate social protection coverage. Various reforms were undertaken already as precondition for ESI Funds support ( II ). Smart Specialisation Strategies for research and innovation were developed to focus efforts on product specialisation with strong market potential and to concentrate investments on each region’s relative strengths. This has also helped improve cooperation between enterprises and public research institutions. The national and regional transport plans have allowed to focus investments on mature and strategic projects, implemented not only with support from ESI Funds, but also from the Connecting Europe Facility (CEF) and national funding. Reform of public procurement, including e-procurement is increasing the efficiency of public spending and building administrative capacity. Portugal is advancing the take up of the European Fund for Strategic Investments (EFSI). As of December 2017, overall financing volume of operations approved under the EFSI amounted to EUR 1.9 billion, which is expected to trigger total private and public investment of EUR 5.5 billion. More specifically, 18 projects involving Portugal have been approved so far under the Infrastructure and Innovation Window (including 6 multi-country projects), amounting to EUR 1.1 billion in EIB financing under the EFSI. This is expected to trigger about EUR 3.2 billion in investments. Under the SME Window, 10 agreements with financial intermediaries have been approved so far. European Investment Fund financing enabled by the EFSI amounts to EUR 801 million, which is expected to mobilise approximatively EUR 2.3 billion in total investment. Over 2 000 smaller companies or start-ups will benefit from this support. SMEs rank first in terms of operations and volume approved, followed by environment. Funding under Horizon 2020, the Connecting Europe Facility and other directly managed EU funds is additional to the ESI Funds. By the end of 2017, Portugal has signed agreements for EUR 678 million for projects under the Connecting Europe Facility. 3. Summary of the main findings from the Macroeconomic Imbalance Procedure in-depth review Introduction The in-depth review for the Portuguese economy is presented in this report. In spring 2017, Portugal was identified as having excessive macroeconomic imbalances, in particular relating to stock variables and the pace of their adjustment. This refers in particular to external, public and private debt, banking sector vulnerabilities and weak labour productivity along with labour market segmentation and a high, albeit decreasing, share of long-term unemployment. The 2018 Alert Mechanism Report (European Commission, 2017f) concluded that a new in-depth review should be undertaken for Portugal to assess developments relating to identified imbalances. Analyses relevant for the in-depth review can be found in: Public finances and taxation (Section 4.1); Financial sector: banking sector, access to finance, private indebtedness, highly negative net international investment position (Section 4.2); Labour market: high youth and long-term unemployment (Section 4.3); Investment: external competitiveness, private and public investment, business environment (Section 4.4); Sectoral policies such as R&D and energy (Sections 4.5.1 and 4.5.2) ( ). 3.1. Imbalances and their gravity The country's net international investment position (NIIP) remains a significant source of vulnerability, as its level of 104.7 % at the end of 2016 is one of the most negative in the EU and goes beyond the estimated prudential and fundamentally-explained thresholds, which stand at of 48 % and 34 %, respectively ( ). The structure of external liabilities remains dominated by marketable debt, which is a riskier type of external financing, despite the shift towards FDI financing flows over the past years. The ratio of net external debt to GDP is also declining but remains high. Sustained current account surpluses are necessary to improve the NIIP to more prudent levels. Aided by the private sector deleveraging process, the current account moved to a small surplus in 2016-2017 that is close to the current account 'norm'( ) implied by fundamentals. Sustaining this surplus over the long run is crucial to address the highly negative NIIP along with the assumed positive balance in the capital account. Yet, even if the surplus were to be kept at current levels, the NIIP would only reach the prudential threshold by around 2030. Private debt is on a steady downward path but still remains above prudential and fundamental thresholds. Both the corporate and household debt ratios are beyond the estimated country-specific prudential thresholds. For households, a debt ratio of 73 % compares with a prudential value close to 30 % of GDP. For corporations, the debt ratio of 99 % is approximately twice as much as the estimated prudential ratio. In addition, the legacy of non-performing loans (NPLs) stands out as a key weakness in the financial system although the scope of the imbalance is declining. The risk exposure is mainly to the corporate sector, which accounts for 65 % of all NPLs. The capacity of the financial sector to deal with NPLs is further limited by weak, albeit improving, profit margins and capital buffers. Public debt remains high and the underlying interest rate burden continues to inhibit public investments. The ratio of public debt to GDP has been relatively stable at around 130 % of GDP since 2014. Better credit ratings are also contributing to lower debt service costs. However, the overall interest burden on the government budget remains one of the highest in the EU. The recent strong increase in job creation has substantially improved the country's labour market. Most indicators improved considerably as headline unemployment dropped to 9 % in 2017. Long-term and youth unemployment also decreased significantly, bringing the scope of imbalances to a much lower level. Productivity in Portugal has been below the EU average over recent years. Although total factor productivity has been a major contributor to the country's potential growth, weak performance in labour productivity keeps income levels below the EU average. Labour productivity is still restrained by product and labour market structural weaknesses, including a high share of low-skilled employees and labour market segmentation. This is despite the ongoing adjustment towards export-oriented sectors. Risks linked to renewed dynamism in the housing sector appear to be contained currently. The rebound in house prices in 2016 and 2017 is seen as a correction from previously low levels of valuation and construction activity and is currently not considered indicative of an imbalance. Nevertheless, it would warrant closer monitoring if the current rapid pace of real house price growth is sustained over the medium term. 3.2. Evolution, prospects and policy responses Portugal's net international investment position improved from 112.0 % of GDP at the end of 2015 to 104.7 % at the end of 2016 but reversed to 105.2 % as of September 2017. This reversal is due to valuation changes (estimated at 3 % of GDP) from the increased price of Portuguese government bonds held by non-residents. The pace of adjustment is expected to improve the external position at a relatively slow pace, as the current account is forecast at a surplus of 0.1 % of GDP in 2017 and 0.2 % in both 2018 and 2019. This is against an estimated annual surplus of 2 % of GDP needed to bring the NIIP to its estimated prudential level of 48 % over a 10-year period. The structure of external liabilities improved over recent years due to a shift from debt to foreign direct investment (FDI). The FDI component in the NIIP widened to 33.0 % as of September 2017 relative to 29.9 % at the end of 2016 and 26.3 % at the end of 2015. The share of net external debt to GDP meanwhile contracted from 100.8 % at the end of 2015 to 94.5 % at the end of 2016 and 92.3 % as of September 2017 (see Section 1).

Policy measures aimed at improving the business environment have taken place that can contribute to improving competitiveness. This was mainly in the area of administrative simplification, identifying ways to further reduce restrictions in business services and regulated professions, and efforts to reduce the backlog in the judicial system. Measures have also been taken to attract foreign investors and improve competitiveness by addressing issues related to internationalisation of SMEs, labour skills and innovation. Private debt has declined over recent years and the outlook remains favourable. In consolidated terms, the private debt-to-GDP ratio fell from 210.3 % at end2012 to 171.4 % at end2016, declining in both the corporate and the household sectors. Data for 2017 confirm that the process of deleveraging continues (see Section 1). This reflects the positive denominator impact of economic growth on debt ratios (passive deleveraging) and a slight decrease in the absolute value of household and corporate debt (active deleveraging). The pace of adjustment appears adequate but it nevertheless weighs on investment and potential growth. The high NPL stock remains a key weakness in the financial system and is being addressed by a three-pronged strategy. The aggregate NPL ratio dropped to 14.6 % in September 2017 from 17.6 % a year earlier, according to ECB data covering domestic and foreign-owned banks. However, it remains among the highest in the EU and well above the EU average. Corporate NPLs are a particular concern as they account for about two-thirds of the total NPL stock. The strategy to reduce the burden of corporate NPLs is detailed in section 4.2.1. The strategy is being rolled out, but some of the measures have been only recently approved or are being implemented. The banks with the largest NPL ratios have submitted plans for substantial reduction in bad loans by 2021 (see Sections 1 and 4.2). Public debt declined from 130.1 % of GDP at end-2016 to estimated 126.4 % at end-2017. The ratio is projected to drop further by an average of around 3 pps in 2018 and 2019. The recent improvement in macroeconomic variables, in particular nominal and potential GDP growth, has made the structural adjustment needed to ensure compliance with the transitional debt rule less demanding. 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 estates and centralised public procurement, to which the government has since committed to add the justice and internal affairs sectors. Despite progress in the spending review, hospital arrears continue rising with the implementation of cost-reducing measures still pending (see Section 1). Labour productivity declined slightly in 2016-2017 but is set to improve as of 2018. The weak performance in both 2016 and 2017 is mostly cyclical due to the high rate of job creation in labour intensive sectors such as tourism-related services and residential construction. The forecast recovery as of 2018 is based on expectations for a less strong and more broad-based increase in employment. Other factors behind the weak labour productivity performance are linked to the low investment levels and some product and labour markets' rigidities such as restrictions remaining in business services and barriers to resource allocation as shown by the high labour market segmentation. The low level of qualification of the adult population also plays an important role. The labour market continues to improve at a strong pace. Unemployment dropped from 11.2 % in 2016 to provisionally estimated 9.0 % in 2017, supported by strong employment growth. This positive trend is expected to continue in 2018 and 2019, though at a slower pace. The activity rate also improved and while the share of long-term unemployed people is almost half of total unemployment, it decreased substantially in absolute terms. As labour market indicators improve, there is no evidence yet of wage overheating, as a large part of the employment growth is skewed to low-wage sectors and some slack on the market appears still in place. Activation and training measures can help improve some of the remaining labour market weaknesses. On top of various measures taken in recent years to promote activation, the one-stop-shops for employment planned for Q12018 will provide integrated services to individuals and employers, giving options depending on their profile and ensuring coordination with other public services. The goal is to improve the effectiveness of activation measures, focusing on the long-term unemployed and younger workers. A programme to improve adults' qualifications (Qualifica) is being implemented. It is an improvement compared with previous programmes since it includes a stronger training component. It also has broad coverage, through an expanded network of qualification centres expecting half a million participants until 2019 focusing on low-skilled adults. 3.3. Overall assessment The balance of risks improved over the past year. In terms of flows, most imbalances are reverting, also helped by the more positive economic environment. This is particularly true for employment conditions, which have improved significantly with unemployment rates now reaching pre-crisis levels. The pace of deleveraging in the private sector is also advancing at a steady pace while the government debt ratio is expected to drop gradually as from 2017. Stock imbalances remain high, mainly in terms of NPLs, public and external debt. Despite the recent improvement, Portugal’s vulnerabilities, which are mostly of a long-lasting, stock-imbalance nature, remain significant. The government and external debt ratios are still high. The large, albeit decreasing, level of NPLs, low profitability and low capital ratios highlight vulnerabilities in the banking sector. Adjustment issues in the labour market have been to a large extent resolved, reflecting the strong employment growth and the fall in unemployment, and the risks there are mostly linked to the low labour productivity, which remains a major weaknesses of the Portuguese economy.



Table 3.1:Macroeconomic Imbalance Procedure assessment matrix - Portugal 2018 (Continued on the next page) Table (continued) (Continued on the next page) Table (continued) Source: Commission Services 4. Reform priorities 4.1. Public finances and taxation 4.1.1.Fiscal policy (public debt and debt developments)* General Government debt is projected to decline in the short and medium term but remains very high. In the context of the global financial crisis and subsequent recession, very high fiscal deficits, the reclassification of off-balance sheet items and entities into the general government perimeter and stabilising interventions in the financial system resulted in a steep rise in general government debt by over 30 pps. of GDP between 2010 and 2013. Following a stabilisation at around 130 % of GDP from 2014 to 2016, the country's gross debt-to-GDP ratio is projected to have seen a first substantial decline to 126 % of GDP in 2017 while remaining one of the highest public debt levels in the euro area. The projections in the following analysis are based on the Commission’s 2017 autumn forecast. Following an acceleration of GDP growth and substantial decreases in interest payments and supported by planned decreases in the cash buffer, the debt-to-GDP ratio is projected to continue its decline by around 2.5 pps. per year in 2018 and 2019 reaching 121 % at the end of 2019. The primary balance is projected to have reached 2.5 % of GDP in 2017 and forecast to decrease to 2 ¼ % in 2018 and 2019, increasing future financing needs (see sections 1 and 3).

Following a more pronounced fall in the short-term, the gross public debt-to-GDP ratio is expected to decline moderately in the medium-term and to stabilise towards the end of the projection horizon. Model simulations of debt sustainability have been carried out that incorporate the scenario of the 2017 autumn forecast until 2019 and other technical assumptions for the medium term ( ). Under the baseline no-policy change scenario, the results suggest that, following the more pronounced decline until 2019, the debt ratio will only decline moderately by around 1pp per year over the medium term before stabilising at around 115 % of GDP towards 2028 (see Graphs 4.1.1 and 4.1.2). Graph 4.1.1:Interest rates and GDP growth shocks Source: European Commission The moderately declining debt-to-GDP trajectory in the baseline scenario is sensitive to potential rises in sovereign yields and to adverse economic developments. The debt sustainability analysis reveals that the debt stabilisation path of the baseline is broadly robust across a number of reasonable scenarios, but plausible shocks could considerably worsen the dynamics of Portugal’s public debt (see Graph 4.1.1). Potential shortfalls in nominal growth, sharp interest rate rises or decreasing fiscal efforts could put the public debt ratio on an upward path. An unsustainable debt trajectory could have adverse consequences for Portugal’s economic stability and lead to negative outward spill-overs via the sovereign risk channel. The very high government debt is a burden on public finances. High public debt implies a smaller fiscal margin for manoeuvre to absorb adverse macroeconomic shocks and cope with possible rises in interest rates. The still relatively high, albeit declining, interest bill (projected at 3.9 % of GDP in 2017 as compared to 2.0 % for the euro area) also restricts the scope for public investment spending. In the absence of further fiscal consolidation and reforms to boost growth, safeguarding fiscal sustainability and continuing to sufficiently reduce debt will be a challenge. The very high debt ratio implies a significant adjustment burden, which requires the conditions that enable debt reduction to be steadily maintained in the coming decades, including sustained economic growth. Sustainability can be safeguarded through permanent budgetary discipline, in line with the requirements of the Stability and Growth Pact (see Graph 4.1.2). The implementation of the reformed budget framework law and strengthened revenue collection could contribute to fiscal adjustment. Healthcare expenditure now accounts for the largest share of ageing costs, posing corresponding implications for long-term sustainability. Recently adopted reforms may affect the medium and long-term sustainability of the pension system. Graph 4.1.2:Fiscal consolidation Source: European Commission 4.1.2.Fiscal sustainability (including pensions and healthcare)* Several reforms have reduced risks to the long-term sustainability of the pension system, while the government has expressed its commitment to duly factor sustainability into any new initiatives. The long-term sustainability of the pension system has been strengthened in the last few years, notably through the increase in the statutory retirement age from 65 to 66 years and by linking future increases to the evolution of life expectancy( ), as well as by restricting access to early retirement. Some recent measures are however expected to contribute to higher pension spending in the short term. In October 2017 a new early retirement scheme without penalty for people who had very long careers entered into force. It allows people who are now 60 years or older and that have made contributions for 48 years or more( ) to the social security or the legacy civil service pension system to retire without penalty. It will be fully operational from 2018. According to the Portuguese authorities, the change is expected to result in a one-off surge of about 11 500 people in 2018 who had been waiting to retire, while the effect on subsequent years should be smaller. Moreover, in addition to the regular pension indexation linked to inflation and GDP growth, an extraordinary update of lower pensions was carried out in 2017. It will be carried out again in 2018, with a particular focus on those pensions not updated between 2011 and 2015. The index for a range of welfare transfers affecting pensions was also unfrozen in 2017 so it can develop in line with inflation and economic growth. Supported by the economic upswing, budgetary transfers to the social security system are set to end in 2018. For the first time in recent years, the extraordinary transfers from the state budget to finance the social security deficit will end in 2018. The end of the extraordinary transfers will be enabled primarily by the projected strong increase in social contributions (+5.6 % or around EUR 900 million) linked to the positive economic environment and the improvements in the labour market. Given the simultaneous increase in the social security system's spending on pensions of 5.1 % (around EUR 800 million), combined with the end of extraordinary transfers, the surplus of the social security system is projected to fall from around EUR 1.5 billion in 2017, to around EUR 1 billion in 2018. Certain revenues are being earmarked to the Social Security Financial Stabilisation Fund. In 2017, the Portuguese authorities started earmarking the revenue collected from the additional real estate tax (Adicional ao IMI) to the reinforcement of the Financial Stabilisation Fund. From 2018 onwards, every year an additional 0.5 % of the corporate income tax revenue will be earmarked to the Fund, progressively reaching 2 % in 2021. The Financial Stabilisation Fund is not meant to be used until the mid2020s, when it is supposed to cover the social security system's deficit. Earmarking revenues in this way does not address the underlying issue of increased spending on pensions, in particular when the earmarking does not relate to new revenues. The short-term sustainability of the health system is not ensured. Hospital arrears continued to increase by EUR 293 million in 2017 in spite of an extraordinary release of around EUR 400 million for the clearance of arrears in December. The average payment period of State Owned Enterprises (SOEs) in the health sector increased by 9 days to reach 112 in the first half of 2017. This is against the overall SOE average payment period which increased by 2 days to reach 72 over the same period. Among the 10 SOEs with the highest increases in operating expenses, 9 are in the health sector. The continuing accumulation of arrears in certain hospitals highlights problems with under-budgeting, monitoring and enforcement practices, along with personnel expenses and increasing demand pressures also being cited as factors. The announced capital injections into hospitals of EUR 500 million both at the end of 2017 and in early 2018 should help decrease arrears in the coming months. The pattern of periodic injections of funds for clearing arrears, however, does not appear to tackle the underlying hospital management issues which result in their accumulation. While measures are being implemented to try to contain hospital expenditure, their impact remains to be seen. The financial management of the regional health administrations, which in the past has led to delayed payments and sometimes heavy financial penalties, has been centralised for a range of areas. Hospitals have increased their efficiency by setting up a shared resource management platform so as to enable the use of National Health System facilities and reduce reliance on the private sector. External evaluations of the boards of directors have also been introduced, as well as multi-year contracts with state-owned hospitals. Starting in 2018, authorities will start rolling out the integrated responsibility centres (attributing more autonomy to hospital teams in an effort to promote efficiency and organisational innovation). In addition, a joint Budget Analysis Unit by health and finance ministries is expected to tackle the hospital arrears problem and to increase the quality of budget planning. Plans to introduce financial incentives for hospitals to reach their targets are also currently being discussed within the Ministry of Finance. Overall, it remains unclear whether these reforms will be sufficient to prevent further arrears and ensure robust control over spending. The burden of healthcare spending on the budget is projected to be among the largest in the EU in the long term. In the long run, pressures from the costs of ageing point to increased public spending on health from 5.9 % of GDP in 2016 (below the EU average of 6.8 %) to 8.3 % in 2070, which represents a 2.4 pp increase compared to the projected EU average increase of 0.9 pp. A comprehensive strategy to tackle the health-related costs of ageing, including chronic diseases, would be beneficial. Future pressures from investment needs are also substantial given that a large part of the equipment in the NHS is out of date. A detailed discussion on access to healthcare is presented in Section 4.3.2. Significant measures are continuously taken to improve cost-effectiveness in the National Health Service. The value of goods and services purchased centrally in the health sector continued its increase in 2017, and is expected to grow further in 2018. Data for the first quarter of 2017 estimated EUR 35 million of savings due to the centralisation of NHS purchasing. Progress has also been made with digitisation, to strengthen the integration of the health system and to reduce redundancies, such as those associated with repeated medical exams. Although the market share of generic medicine in the NHS market has increased greatly compared to the 2011 level, the share seems to have broadly stabilised in recent years. The market share of certain biosimilar medicines( ), however, grew largely over the last two years. This development is being promoted through minimum-market share objectives for specific biosimilars in hospitals, as well as improved information about both generics and biosimilars to prescribers. More generally, annual medicine price revisions and agreements with suppliers continue to yield savings. 4.1.3.Fiscal framework and SOE* The spending review exercise is gradually being expanded into new sectors. The expenditure review continues to cover education, healthcare, state owned enterprises (SOEs), public sector real estate management and centralised public procurement, with justice and internal affairs being the most recent additions. Some progress has already been made in the justice sector, with advancements in the 'Closer Justice' Plan to strengthen efficiency, due to be completed in 2019; as well as the 'Tribunal+' project which aims to optimise the working time of justice officers. In addition, there are plans to reduce the costs and inefficiencies associated with the legal treatment of seized vehicles are in development. A series of reforms in the internal affairs sector have also been planned but are not yet ready to be implemented. The reforms include the outsourcing of support functions to free up resources for operations and eliminating redundancies and replicated administrative tasks. Improved human resource management to reduce absenteeism was presented as a priority for the 2018 spending review. The authorities estimate that EUR 60 million (10 in the education sector, 50 across other sectors) will be saved by reducing absenteeism in 2018. The focus will initially be on the education sector, where a review of medical panels, combined with the introduction of a new monitoring system, is expected to enable unnecessary sick leaves to be identified. If the approach proves successful, the intention is to apply the new measures across the remaining public administration sectors. A performance-related scheme aiming to incentivise civil servants to develop new ways of reducing expenditure without compromising public service provisions has also been adopted. This scheme does not apply to SOEs, and therefore not to hospitals either. Ambitious savings targets for the 2018 spending review are a positive development. The total projected savings from the spending review exercise in 2018 amounts to around EUR 290 million (0.14 % of GDP) in a single year, compared to the expected cumulative savings of 0.1 % of GDP over 3 years announced in the 2017 budget. Overall, the inclusion of additional sectors and the introduction of more ambitious savings targets are welcome improvements. A broadening of the exercise to cover an even larger share of general government spending would represent another positive step forward. There are further delays in implementing of the reformed Budget Framework Law (BFL). Together with an integrated accrual-based public accounting system, the BFL aims to improve management ownership, and ensure effective budgeting and budget implementation, as well as monitoring and reporting at all public administration levels focussing more strongly on medium to long-term accountability. Preparatory work, mostly the setting-up of IT systems, has been progressing, especially concerning the state accounting entity project ( ). In terms of regulatory preparation a series of decree laws will require adjusting and consolidating. While the effective application of the new accounting framework should start in January 2018, the 2019 budget will not yet be prepared under the new framework due to the accumulating delays in implementing the BFL so far. As full completion by the 2018 target is no longer achievable, the three-year transition period for full BFL application will have to be extended with a phased postponement in applying most of the new BFL features. Overall, while the preparatory steps for thoroughly implementing the BFL have progressed, albeit more slowly than originally planned, it would appear important to maintain an ambitious timeline in the upcoming amendment in order to keep up the momentum for implementation in the short term. While the financial position of SOEs is improving the lack of a systematic approach to budgetary transfers to SOEs remains an issue. The government estimates a net income for non-financial public companies of EUR 461 million in 2017, projected to fall to EUR 118 million in 2018 down from EUR 1.3 billion in 2014. Operational results also continue to improve (except in the health sector), albeit more slowly than in previous years, and despite the rising personnel costs linked to the unfreezing of wages. The total non-consolidated debt of public corporations included in general government remains high, however, at 19.0 % of GDP (approximately EUR 36 billion) in September 2017. This represents a fall of 1.3 pp of GDP relative to September 2016 (Bank of Portugal, 2017). According to the DBP, authorities have committed to limit the overall growth of public company debt to 2 % per year( ) (net of capital increases and the financing of new investments), although a more ambitious debt reduction target could be considered. A debt management and recapitalisation plan for SOEs is ongoing to reduce indebtedness and lower interest costs. The current ad-hoc practice of budgetary transfers to SOEs would benefit from being more predictable, however, in order to minimise moral hazard; promote the right incentives; and underpin a solid, long-term improvement in SOE sustainability.

Measures to improve SOE monitoring are ongoing although their impact remains to be seen. The upgrade of the SIRIEF( ) system to automatically draw information from the accounting systems of public companies will be widely applied in 2018. Activity and Budget Plans submitted by SOEs to UTAM (Ministry of Finance's task force on SOE monitoring), are beginning to be evaluated more comprehensively and with a longer time horizon (3 years). In 2018 the analysis of the impact of these plans on public accounts will no longer be limited to larger companies or groups, and will be carried out in a more regular and systematic way. Beginning in 2018, instruments ensuring that the Activity and Budget Plans are properly implemented will be put in place. These include early warning mechanisms and an assessment methodology allowing public companies to be ranked by their degree of risk so as to prioritise the follow-up effort. A detailed cost reduction programme can be required from at-risk SOEs. Accountability will also be improved through the introduction of incentives for good governance and for reaching objectives. Furthermore, SOE investments will be evaluated by UTAM on a case-by-case basis. 4.1.4.Taxation issues including tax administration* Net revenues of new taxes appear limited while the government intends to ensure the broad stability of corporate tax legislation. The revenue from the new tax on sugary drinks up to October 2017 seems in line with expectations regarding the EUR 80 million target for 2017. However, the progressive additional real estate tax introduced in 2017 and earmarked for the Social Security's Financial Stabilisation Fund may bring significantly lower net revenue than expected. While gross revenues of around EUR 130 million are expected for 2017 only EUR 50 million has effectively been assigned to the Stabilisation Fund. The reduced transfer to the Fund reflects the expected impact of the deductibility of the additional real estate tax for rented-out properties in personal income tax declarations. Corporate income tax (CIT) rules have been broadly kept stable in 2017 except for a limited broadening of the scope of the tax allowance for corporate equity (ACE) intended to decrease the corporate debt bias (see below). While the 2018 draft budget did not include any major changes to CIT rules either, Parliament adopted an increase of the State surcharge from 7 % to 9 % for large companies with profits exceeding EUR 35 million. This was accompanied by a measure increasing incentives for reinvesting profits. A new reform of personal income tax (PIT) is set to significantly affect revenue from direct taxation as of 2018. In addition to the already previously planned full abolishment of the PIT surcharge also for higher tax brackets, new PIT reform measures were introduced in the 2018 budget that aim to lower the tax burden on low-to-middle income earners( ). The reform measures include inter alia an increase in the number of tax brackets and an increase in the level of the net income guarantee ('mínimo de existência'). The corresponding reductions in PIT revenue could be somewhat higher than projected in the 2018 Draft Budget report (see Euromod-based simulation in Box 4.1.1). As the withholding tax tables may not already fully reflect the reform as of January 2018, part of the revenue losses may however only materialise when the 2018 PIT declarations are made in spring 2019. The PIT reform is estimated not to have an income inequality-reducing impact, as most of the benefits would be concentrated on the top half of the income distribution (Box 4.1.1). Despite attempts to broaden the tax base reduced VAT rates are widely used. The VAT gap of Portugal (11.46 %), measuring tax collection efficiency is slightly below the EU average (12.77 %) and has decreased to its lowest level since 2011 according to the last available data (2015). However, the VAT policy gap of Portugal, which measures the impact of reduced rates and exemptions on VAT efficiency, remains considerably higher than the EU average (50.75 %, compared to an average of 44 %, see CASE, Study and Reports on the VAT Gap in the EU-28 2017 Final Report, TAXUD/2015/CC/131, 2017, p.54.). This needs to be assessed in light of recent changes to the VAT legislation that are not yet reflected in the indicators above, which have further extended the application of reduced rates( ). Hence, it appears worthwhile for Portugal to consider comprehensively assessing the impact of past changes on VAT system efficiency. Recent measures have been enacted to tackle the corporate debt bias in taxation. Historically, the tax system itself has encouraged debt financing, through a differential corporate tax treatment of debt and equity, which incentivised businesses to accumulate excessive amounts of debt. Since January 2017, deductible interest expenses will be limited to the higher limit of 30 % of cash flow income or EUR 1 million. In addition to the recently revised ACE rules, this is expected to have some positive impacts in lowering the corporate debt bias, especially for companies with very high amounts of debt. The new ACE rules apply only to new equity investment. They avoid brining undue benefits to pre-existing investments, while being extended in scope. Consistent monitoring and evaluation of the performance of these two measures would allow to ascertain if further refinements are needed. Dealing with taxes in Portugal is still burdensome, despite recent simplification efforts. In addition to past measures on improving the tax administration's efficiency (European Commission e), a series of new administrative simplification measures are included under Programa Simplex. Some of them were already introduced in 2016 (such as the online registry of non-habitual residents for PIT). Moreover, in the framework of the strategic plan against tax fraud for 20152017, other measures have been implemented. The number of e-invoices issued during 2016 increased by 3.6 % compared to the previous year, and taxpayers largely make use of online declaration of PIT forms (94.97 % of the total). Other initiatives include the almost full pre-filling of personal income tax returns and a new digital service for obtaining investment tax codes. These new processes have significantly reduced the elapsed time for handling procedures, increased taxpayer satisfaction and reduced administration costs. However, the average number of hours needed to comply with tax obligations (243 hours) remains the fifth highest among EU and EFTA countries (World Bank, 2017b). Moreover, the recurrent budget allocated to IT, expressed as % of the total recurrent budget of the tax administration, was only 5.7 % in 2015 (OECD). Increasing the efficiency and coordination between the different services within the tax administration remains a priority. Close monitoring of the overall impact of the measures would help ensure the cohesion of the system and identify weaknesses and areas for improvement. Improving the efficiency in collecting tax arrears remains a challenge. Significant court backlogs remain regarding tax proceedings, which hamper the administration's efficiency in collecting tax arrears. In 2015, the % of total Portuguese tax debt that was older than 12 months remained among the highest in the EU (87.5 % of CIT-, 84.8 % of PIT-, and 90.9 % of VAT-related tax debt), which suggests the current procedures are not agile. Moreover, the total year-end tax debt (including debt considered not collectable) as a % of total net revenue was 36.34 % in 2015, which represents an increase of 6.79 pps in the period 2011-2015 (OECD). Box 4.1.1: Impact of the 2018 Personal Income Tax reform: EUROMOD based simulation of the impact of the 2018 PIT reform In 2018 Portugal is implementing a Personal Income Tax (PIT) reform affecting the number of tax brackets and the net income guarantee, in addition to the previously decided full reversal of the surcharge for the higher tax brackets. The size of the ensuing revenue and distributional effects were measured using EUROMOD ( III ) in a simulation exercise by the Joint Research Centre and DG ECFIN. The most important new element of the 2018 PIT reform is the redesign of the tax bracket structure via the introduction of two additional brackets (dividing into two the previous second and third brackets) and a decrease of the lower limit of the fourth tax bracket. Thus, the marginal tax rates for the lower parts of the previous second and third brackets have been reduced from 28.5 % to 23 % and from 37 % to 35 % respectively. At the same time the lower limit of the previous fourth tax bracket with a marginal tax rate of 45 % has been reduced from EUR 40 522 to EUR 36 856. In addition to the tax brackets redesign the second major new element is the update of the tax-exempted net income guarantee ('mînimo de existência') that is now linked to the social support index (IAS). Further to the update of the IAS to EUR 428.90 EUR for 2018, the net income guarantee has thus risen from EUR 8 500 in 2017 to EUR 9 006.90 in 2018 (i.e. 1.5 IAS x 14 months). A third element is the abolition of the PIT surcharge. In line with the political decision taken already in the 2017 budget discussions, the PIT surcharge, that was still applicable at reduced rates for the full 2017 income for the higher tax brackets, has been fully abolished for all tax brackets for 2018 income (in terms of withholding tables it had already been gradually phased out by 1 December 2017). The simulation used 2017 Portuguese tax-benefit calculation rules as a baseline scenario. In order to isolate the effects of the full surcharge abolishment, the change in the tax bracket structure and the rise in the net income guarantee, these three elements have been simulated in separate incremental steps. The full abolishment of the PIT surcharge for 2018 revenue also for higher tax brackets results in a negative Government revenue impact of around EUR 140 million. The change in the tax brackets and the rise in the net income guarantee imply additional revenue losses of around EUR 440 million and EUR 30 million respectively. Thus, the total implied revenue losses as compared to the 2017 baseline would add up to around EUR 610 million, i.e. around 5 % of the baseline PIT revenue. The revenue losses of around EUR 470 million related to the change in the tax brackets and the rise in the net income guarantee are somewhat above the estimate of around EUR 385 million included in the draft budget report. All three measures have positive effects on the mean equivalised household disposable income ( IV ) in aggregated terms. In distributional terms, both the full reversal of the surcharge for the higher tax brackets and the change in the bracket structure lead to increases in the Gini coefficient, implying a more unequal distribution of income, which is only marginally offset by a minor decrease of the coefficient induced by the rise in the net income guarantee. The surcharge abolishment for high brackets benefits basically only the last decile of the income distribution. As the lower five deciles were already mostly exempted from personal income tax or paying the lowest bracket rate, the change of the structure for the intermediary brackets mostly benefits the upper five deciles. The rise in the net income guarantee mainly benefits the mean equivalised disposable income for the fifth decile. The overall distributional impact thus shows a regressive pattern, with the main beneficiaries being the households on the top-half of the income distribution. 4.2. Financial sector, private indebtedness and housing market 4.2.1.Banking sector* The capitalisation and profitability of Portuguese banks are below EU peers, but asset quality is improving. Strong economic performance, lower unemployment and improved consumer confidence can be traced in the gradually improving outlook for the banking sector. Better prospects for the financial sector also reflect capital increases, the restructuring efforts taking place throughout the banking sector, and the weak but slowly improving asset-quality indicators. Yet, profitability forecasts remain poor, due to the following factors: the high amount of non-performing loans (NPLs) on the balance sheet of Portugal's lenders, the relatively weak credit conditions and the low interest rate environment (see below). Despite the weak profits, which have been preventing banks from generating capital organically and led to equity increases directly from shareholders capitalisation levels are gradually converging towards European peers. The business model followed by many Portuguese banks consists of increasing fees and the prices of banking operations. In the long term, this could be threatened by digitisation trends which will increasingly provide lower cost service solutions for consumers. Tackling the bad asset problem is a priority for both banks and national authorities. Throughout 2016 and 2017 banks managed to bolster their capital levels through a variety of measures and, more importantly, to attract international investors. The authorities in turn took several important decisions to allow banks to improve their profitability and deal more efficiently with legacy bad debt. Key measures included extending the duration of the loan to the national resolution fund, the sale of Novo Banco and the announcement of a comprehensive three-pronged strategy to deal with bad assets. The three largest banks holding a substantial share of all NPLs, created a credit management platform explained further down. Savings still grow despite the lowest deposit remuneration on record (see Graph 4.2.1). Aggregate deposits are still growing and account for the vast majority of the Portuguese banks’ funding. Contrary to other Member States, Portuguese banks are forbidden by law to charge negative interest rates, even to large companies. This increases the incentives for multinationals to deposit excess liquidity in Portugal. Portugal has one of the highest NPL ratios in the EU. By the end of September 2017 the overall NPL ratio was 14.6 % (European Central Bank) compared to 17.2 % at end-2016. In absolute terms NPLs decreased by EUR 10.2 billion since the peak, mainly due to NPL portfolio sales and a diminished flow of new NPL. Nonetheless the ratio is still approximately three times the euro area average (European Central Bank, Q3-2017). Without the reduction in total loans (denominator effect) the ratio would have come down faster. Broken down by sector, non-performing exposures of mortgage loans amount to 6.5 %, consumer loans 9.6 % whereas corporate NPLs are still 27.5 %; compared to 7.2 %, 12.4 % and 30.3 % in June 2016 respectively. On the back of falling NPLs in absolute terms the average coverage ratio rose slightly to 45.9 % (ECB), 2.7 pps higher than in June 2016 (EU average is 45 %). Graph 4.2.1:Saving with domestic banks Source: Bank of Portugal The strategy to address NPLs already covers the most important aspects, and some steps have been taken to facilitate their recovery. The issue of legacy non-performing assets is recognised by the authorities as a key vulnerability of the financial system. The focus is on NPLs from non-financial corporations, which make up 65 % of all NPLs and were valued at around EUR 25 billion. This issue is being addressed by a three-pronged strategy: (i) changes to the judicial, legal and tax systems, (ii) prudential/supervisory measures led by the Single Supervisory Mechanism (SSM); and (iii) NPL management solutions (discussed in the next paragraph).The strategy’s legal strand is essentially focused on enabling the early restructurings of firms, while ensuring that non-viable companies are prevented from applying for various pre-insolvency proceedings and thus benefitting from creditors’ protection — often used as a strategy to delay the inevitable liquidation. Also, the strategy’s judicial pillar is focused on expediting insolvency proceedings (see Section 4.4.4). The secondary market for bad assets was further boosted by the Credit Recovery Funds, which started the divestment of some of the assets that were in the funds. The strategy’s supervisory strand focuses on providing guidance to banks on how to efficiently decrease NPLs. In addition, steps have been taken to tackle constraints to the recovery of NPLs. They target (i) the ability for banks to fiscally recognise write-offs; and (ii) the incentive for creating a secondary market for NPLs, by enabling new servicing companies to enter the market. The success of this strategy heavily depends on how well it is implemented. Banks are taking measures to address their high level of NPLs. Banks have submitted five-year NPL reduction plans to the supervisor. The plans are based on SSM guidance and include measures such as cash recoveries, foreclosures, sales of NPLs and write-offs, and the use of SSM guidance on NPLs. Furthermore, various NPL management solutions are part of the third pillar of the comprehensive strategy to tackle the banking system’s legacy NPLs. Among these, a relevant initiative being put forward by banks is the ‘coordination platform’. This platform is a specific approach to deal with NPLs from non-financial corporations (NFCs), which aims to promote strengthened creditor coordination to expedite credit restructuring. The platform also intends to attract both public and private funds and technical assistance to restructure viable businesses but it remains to be seen how it will be operationalised. While this platform will not solve once for all the NPL problem, it will be helpful in the medium term for more challenging cases. Profitability remains very low seen from a European perspective, in part due to non-recurring restructuring costs and high impairment levels, hampering the build-up of organic capital. While net intermediation income remained relatively stable – predominately thanks to lowered deposit remuneration – the lowered flow of impaired loans in 2017 explains why profitability improved somewhat. Banks cut costs through closing branches and early retirement schemes, both of which have high up-front costs while only yielding benefits later. Consequently the cost-to-income ratio remains high at 62.5 % (EBA data for the biggest banks) in June 2017. Given that Portugal still has one of the highest branch densities in the EU more consolidation efforts seem warranted. Concerning return on equity ECB data from June 2017 shows 0.2 % for the Portuguese banks as a whole, compared to 0.6 % in June 2016. Portuguese banks managed to issue shares and attract shareholders yet their capital base remains low. The system's capital and reserves amounted to EUR 36.3 billion in September 2017, increasing from EUR 29.8 billion in December 2016. CGD, BCP and Montepio together strengthened their capital in 2017 by more than EUR 6 billion in total. Still, Portuguese banks are amongst Europe's least capitalised. Banco de Portugal cites CET1 with 13.2 % in June 2017. Further increases are planned. Lone Star, who bought Novo Banco in October, has injected EUR 1 billion during 2017. Novo Banco will have to issue EUR 400 million in subordinated debt until the end of 2018. CGD also plans another EUR 430 million Additional Tier 1 bond issue in 2018. These additional injections will not change the picture substantially but contribute to bridge the gap to EU peers. Nevertheless, if Portuguese banks are to become more profitable, they may have to generate capital organically and dispose more quickly of NPLs.

Improved profitability prospects attracted foreign investors to invest in Portuguese credit institutions. Foreign investors play an increasingly important role in the Portuguese banking sector. BPI continued deconsolidating its Angolan exposure and in February 2017 the Spanish CaixaBank group reinforced its position in the bank, which now amounts to 84.5 %. Millennium BCP, the second biggest bank in the system, increased capital and added the Chinese conglomerate Fosun to its list of strategic shareholders. Santander Totta, owned by the Spanish Santander group, continues to grow its balance sheet through consolidating its operations with Banco Popular’s Portuguese subsidiary, following the resolution of Banco Popular Español. Following a three-year process Novo Banco’s sale was completed in October 2017 when US private equity fund Lone Star closed the deal to acquire 75 % of the bank in exchange for Novo Banco being recapitalised by EUR 1 billion. Fully Portuguese owned banks such as the sector’s biggest bank CGD and Montepio, the country’s sixth largest, also carried out capital increases, which in the case of CGD was conducted through public recapitalisations as it is a 100% state-owned bank. Montepio changed into a limited liability company, a legal status that reinforces shareholding, governance and the strategic orientation of the bank. 4.2.2.Housing market* Graph 4.2.2:Valuation gap on price/income, price/rent and fundamental model valuation gaps Source: European Commission Real estate prices are back to 2009 levels and the pace of mortgages decrease slowed down. House price inflation rose from 7.1 % in 2016 to 10.4 % year-on-year in Q32017. The deflated house price index increased by 6 % in 2016 and is estimated to have risen even more in 2017. Real estate prices are back to 2009 levels implying a 20 % real appreciation since 2013 following a depreciation of 17 % between 2010 and 2013. Commercial real estate prices grow slower than those for residential housing. Newly granted mortgages between January and September 2017 more than quadrupled from their 2012-2013 average. Yet they are only around a quarter of the 2003 to 2007 average. Consequently amortisations still outweigh new mortgages and their stock still shrinks with 2.3 % year-on-year by the end of Q32017. If adjusted for all non-transaction related issues ( ) the decrease is 1.4 %. Prices are still recovering from the crisis slump with price hikes mostly restricted to tourist areas. Concentration of price hikes in tourist areas, including projects for transforming residential properties into accommodation facilities suggest that the housing market is currently mainly driven by external demand and tourism-related investments. Domestic factors appear much weaker as the stock of mortgage loans is still declining. The price increase in 2016-2017 comes after a long period of decline and is so far seen as a correction of past undervaluation rather than an accumulation of new imbalances. Based on the synthetic valuation gap (an average of a model-based assessment and deviations from price-to-income and price-to-rent ratios), real house prices are still deemed slightly undervalued. Nonetheless, the rapid price increases are affecting internal demand and might aggravate the issue of housing affordability (Section 4.3.2). Remaining restrictions in the construction sector should be assessed to understand if they are a barrier for increasing housing supply (see Section 4.4.3). 4.2.3.Access to Finance* The amount of bank loans granted to the corporate sector continued to contract but at a slower pace. Overall private sector loans fell by 4.0 % between September 2016 and September 2017. Company loan stock fell by 6.7 %. As Portuguese banks have off-loaded some NPL portfolios, the adjusted decline is only 1.2 %. The loan-to-deposit ratio fell slightly from 80.9 % in Q2-2016 to 79.4 % in Q22017 — by shrinking loans rather than by growing deposits. The contraction in providing credit affects both SMEs and large companies. In September 2017 the proportion of debtors with overdue credit amounted to 26.4 % (Bank of Portugal). The deleveraging process is ongoing with an aggregate reduction of private debt. As a result firms' access to bank loans is reduced. Additionally, interest rates in Portugal are among the highest in the euro area (2.75 % in September 2017 against 1.57 %). Portuguese SMEs are highly dependent on bank credit. Loans to micro-companies and SMEs accounted for the largest share of the total loans to Portuguese NFC. SMEs have higher NPL ratios (Graph 4.2.3). Micro and small corporates are somewhat riskier than bigger corporates, which firstly is reflected in the higher NPL rations on that segment and secondly explains also the higher interest rates they receive. Big corporates face fewer impediments to finance through alternative sources such as issuances of bonds and equity. Graph 4.2.3:Overdue loans as % of total loans by NFC's size Source: Bank of Portugal A high level of NPLs is making banks more prudent when allocating credit. While corporate loans attributed to firms in the best risk quartile are growing among heavy interbank competition, loans to heavily indebted firms are on the other hand decreasing. Still, Portuguese companies benefited in general from the low interest rate environment which facilitates to a certain extent and al