The capital buffers in Portugal’s banks are not big enough to deal with their bad loans, the International Monetary Fund warned, and it urged banks to clean up their balance sheets to help the country grow and cut its debt burden.

In a report of the fifth monitoring mission following the end of Portugal’s bailout in 2014, the IMF board said that despite a reduction in risk-weighted assets, Portugal’s banks had the second-lowest capital ratio in the European Union, at 12.3 per cent.

Although total capital in the banking system is above regulatory requirements, it “appears insufficient to tackle the likely capital shortfall in the system if non-performing loans are fully provisioned for”, the IMF said.

“A comprehensive balance sheet clean-up” is needed to break a vicious circle of weak banks, high non-performing loans and slow growth, the IMF said.

It called on regulators to ensure that banks set ambitious targets for reducing bad loans and forced them to increase coverage ratios with additional provisions.

Portugal’s banking system is still reeling after the state had to rescue two lenders in 2014 and 2015.

After years of capital shortages, state-owned Caixa Geral de Depositos is being recapitalised by €5 billion. The largest listed bank, Millennium bcp, completed a €1.3-billion capital increase.

The IMF said the Geral de Depositos recapitalisation weighed on public debt in late 2016, when it rose to 130.5 per cent of gross domestic product, and it expects only a modest reduction to some 130 per cent in 2017.

High public debt complicates the situation in Portugal. It leaves no fiscal room for the state to finance a “bad bank” for non-performing assets, so banks have been able to raise additional private capital themselves. That requires more cost cuts and measures to improve their weak profitability.

Portugal’s economic growth slowed to 1.4 per cent last year from 1.6 per cent in 2015 as investment fell and private consumption slowed. Still, the government says it cut its budget deficit to 2.1 per cent of GDP or less from 4.4 per cent in 2015. It targets 1.6 per cent in 2017.

The IMF said that forecast “depends in large part on optimistic revenue projections, raising risks to execution”. It called for durable spending reforms rather than one-off adjustments. Its forecast this year’s deficit at 2.1 per cent.