An extended period of real convergence in living standards towards the euro area average came to a halt in 2000 and the Portuguese economy continued to slow down in 2002 (Figure 1). The downturn reflected the international weakening of activity and, most of all, the adjustment process of private demand that had started mid-2000. These developments took place against a background of sizeable macroeconomic imbalances generated in the late 1990s, including a large external deficit and high household and corporate indebtedness. In 2001, these factors outweighed the positive stimulus associated with an expansionary fiscal policy and the relatively favourable monetary conditions that characterised the Portuguese economy. In 2002, the more restrictive policy stance, in particular the tight fiscal measures adopted, intensified the slowdown of domestic demand. The recovery of the Portuguese economy is projected to lag the euro area and will be heavily dependent on external demand, as domestic demand is expected to remain subdued for some time.