In order to enter the European Monetary Union (EMU) in January 1999, Portugal agreed to cut its fiscal deficit and undertake structural reforms. The EMU brought exchange rate stability, lower inflation, and lower interest rates. Falling interest rates, in turn, lowered the cost of public debt and helped the country achieve its fiscal targets. However, private sector borrowing increased dramatically. By 2001, the economy was in serious external imbalance, with a large current and capital account deficit. Portugal was the first country to breach the Eurozone's Stability and Growth Pact budget deficit target of 3%, with a gap equal to 4.2% of GDP. The Government of Portugal (GOP) met the 3% target in 2002 and 2003, but only with substantial one-off revenues. Despite a hiring freeze and other measures, the Portuguese general government deficit was 3% of GDP in 2004 and is projected by the European Commission to reach almost 6% of GDP in 2005 and close to 5% of GDP in 2006. To comply with EU requirements to maintain fiscal austerity, the 2006 budget presented by the new Socrates government in October 2005 includes reforms of pension schemes and public administration, including career and wage scales. There is a freeze on public sector promotions until the end of 2006. Revenue producing measures, adopted in mid-2005, include an increase in VAT from 19 to 21%, and improved tax collection.

The Portuguese economy experienced a 1.3% decline in 2003 but showed a slight recovery in 2004 of 1.1%. The European Commission projects GDP growth of below 1% in 2006 and close to 1.25% in 2007. The government believes that labor reform legislation, which took effect in early 2004, corporate and personal tax cuts in 2004 and 2005, and other changes will support a strong economic recovery and a return to faster growth. Unemployment reached 7.7% in the third quarter of 2005.

Portugal's economy is based on traditional industries such as textiles, clothing, footwear, cork and wood products, beverages (wine), porcelain and earthenware, and glass and glassware. In addition, the country has increased its role in Europe's automotive sector and has a world-class mold-making industry. Services, particularly tourism, are playing an increasingly important role. Portugalís EU funding will be cut by 10%, to 22.5 billion euros, during the 2007-2013 period. EU expansion into eastern Europe has erased Portugal's historic competitive advantage and low labor costs. The government is working to change Portugal's economic development model from one based on public consumption and public investment to one focused on exports and private investment.