Portugal's opposition parties have defeated austerity measures in parliament, pushing the minority government to the point of collapse.
The rejection of the proposed spending cuts and tax rises is likely to trigger an international financial rescue.
The vote late on Wednesday came on the eve of a European Union summit to finalise a eurozone debt crisis plan.
The prime minister is expected to address the nation in the coming hours amid speculation that he is to resign.
Economist Intelligence Unit analyst Kevin Dunning told the BBC that this is "crunch time" for Portugal.
"This could be the week when they have to activate the bail-out fund," he said ahead of the anticipated government defeat.
Last year, Greece and the Republic of Ireland had to accept massive rescue packages after markets lost faith in their governments' efforts to deal with their debt burdens.
Portugal's financial collapse would likely spark another round of nervousness in financial markets and may revive concerns about the larger Spanish economy.
Opposition parties said the austerity plan - cuts in welfare, tax rises, and increases in public transport costs - went too far.
Prime Minister Jose Socrates had said he would no longer be able to run the country if the package is rejected.
Major international lenders have been wary of Portugal's attempts to avoid tapping eurozone bail-out funds by raising money in the debt markets.
The yield on Portugal's 10-year bond hit a new high of 7.52% in late trading on Wednesday ahead of the key budget vote, an indication of investors' concerns about the country's ability to pay back its debts.
On Thursday eurozone leaders begin a two-day summit at which they hope to finalise details of a "grand bargain" to deal with the 17-nation group's debt burden.
However, a draft communique for the summit indicated that a decision on how to increase the size of the existing bail-out facility - used to rescue the Republic of Ireland - has now been postponed until June.