HONG KONG, CHINA - HONG KONG'S economy unexpectedly shrank in the second quarter, its worst performance since the height of the Sars outbreak in spring 2003, hit by the widening impact of a US downturn and high inflation that undermined domestic consumption.

Gross domestic product contracted 1.4 per cent, seasonally adjusted, from the previous quarter, after a revised 2 per cent expansion in the first quarter.

The territory follows on the heels of second-quarter contraction in Japan and Singapore as the impact of a US slowdown and faltering European demand filtered through to Asia.

'Yes, the growth engine from domestic demand is decelerating and will provide less of a buffer for softening external demand,' said Ms Irina Fan, an economist at Hang Seng Bank. 'But the labour market is still relatively tight compared with the last 10 years and people still have confidence to spend. So we don't see a recession.'

The government maintained its full-year 2008 forecast for economic growth of 4 to 5 per cent but had previously said it would come in near the top of that range. That marks a sharp slowdown after four years averaging annual growth of 7.3 per cent.

'We expect in the second half the economy will grow at a more moderate pace,' government economist K.C. Kwok told a press conference.

'The global financial market problems will continue for some time and the slowdown in the global economy will not be over shortly. It will go into 2009 and continue to affect us,' Mr Kwok said.

Compared with a year earlier, second-quarter GDP rose 4.2 per cent, lagging forecasts for a 5.6 per cent expansion and the slowest growth since the fourth quarter of 2003.

Exports fell in June and private sector business activity contracted in July for the first time since December 2004, according to a purchasing managers' index.

First-half earnings reports meanwhile have been mixed with the territory's flagship carrier Cathay Pacific Airways booking a shock loss.

'Hong Kong is the second-most open economy in Asia ... the global economic and financial turmoil is starting to take its toll,' said Rob Subbaraman, Asia economist at Lehman Brothers.

As export growth has eased, consumption and investment have become the drivers of economic growth.

Consumption fell 1.6 per cent in the second quarter seasonally adjusted from the previous quarter, excluding spending by tourists, as locals were hit by a 20 per cent slump in the stock market in the first half and a surge in inflation to 6.1 per cent by June.

Compared with a year earlier private consumption grew only 3.1 percent, easing from a revised 7.9 per cent increase in the first three months of the year.

Investment rose 4.3 per cent in the second quarter, slowing from a 9.9 per cent surge in the first quarter.

The government raised its average headline inflation forecast for 2008 to 4.2 per cent from 3.4 per cent and said the underlying inflation was likely to average 5.5 percent this year, up from a previous forecast of 4.5 per cent.

GDP data was released after the close of the stock market, which fell 1.09 percent on Friday. -- REUTERS