Recession-hit Portugal faces prospect of EU fines

Portugal, one of the European Union's poorest countries, has become the first nation to face the prospect of huge fines for breaking the rules underpinning the single currency.

The European Commission has started proceedings against Lisbon for failing to keep its budget deficit under control last year. In theory, massive fines could be imposed – equivalent to 0.5 per cent of Portugal's gross domestic product. In reality that is highly unlikely unless the problem persists for years.

Nevertheless the latest test of the euro has raised significant doubts about the operation of its rule book – the Stability and Growth Pact.

Designed to impose financial discipline in the 12 countries inside the eurozone, the pact is coming under growing strain during the economic downturn.

France has led calls for a more flexible interpretation of the rules to allow a looser economic stance during times of stagnation. Countries in times of recession will tend to earn less from taxation, while at the same time pay out more in welfare support.

Under stability pact rules eurozone countries are expected to keep their budget deficits below 3 per cent, so countries are not spending very much more than is paid into their coffers. The aim is to create a stable euro.

The previous administration in Portugal went on a pre-election spending spree and, in March, the EU statistical office refused to approve its projections, judging them to be suspect. This week Portugal's new, centre-right government, which was elected in April, said publicly that the true 2001 deficit was 4.1 per cent.

To try to get the situation under control it has increased VAT from 17 to 19 per cent and slapped a recruitment freeze on the public sector.

But spending cuts – described by the Finance Minister, Manuela Ferreira Leite, as "deep and violent" – could hit recovery prospects. The minister has admitted that the budget deficit for this year, expected to be 2.8 per cent, may creep over the 3 per cent barrier. A fine – possibly in the form of suspension of the €6bn (£3.7bn) due to Portugal through cohesion funds over six years – would make matters even worse.

Significantly, much bigger eurozone countries – Germany, Italy and France – are also pushing up against the 3 per cent ceiling. Because of the size of their economies, the ability of these countries to obey the rules will have a much greater impact on the credibility of the pact with the markets – and hence the currency's health. Diplomats will be watching to see what the lengthy procedures against Lisbon produce.

Pedro Solbes, the European Commissioner for Economic and Monetary Affairs, will have to wait until September for formal backing from other commissioners for his move against Portugal. EU central bank and finance officials will then comment on their findings before they go to finance ministers in October or November. The ministers have to agree to launch action against Lisbon, setting a maximum four-month deadline for Portugal to set a timetable for bringing the deficit back below 3 per cent, probably over the next year. Only then would fines apply.

Despite the growing controversy over the workings of the pact, the euro's performance on the currency markets has not been affected. That, however, may only be because traders are marking the dollar down, alarmed about the series of accounting scandals in the US.