The Hong Kong Government has blamed the Sars virus the country's third economic recession in six years.
Sars had a huge impact on Asia
Figures showed gross domestic product shrank by 3.7% from April to June, compared with the first three months of the year.
The pneumonia-like virus prompted worldwide warnings against travelling to the territory, leading to a sharp drop in the number of visitors and causing businesses to go bankrupt.
Economic forecasters, however, expect Hong Kong's economy to rally in the second half of the year as tourism begins to pick up after the virus was contained.
"The spread of Sars in Hong Kong since mid-March had dealt a heavy blow to the economy," the government said.
It said tourism, air travel and the hotel industry were hit particularly hard in April and May.
The economy had shrunk by a more modest 0.3% in the first three months of the year before the virus entered its worst phase.
Consumer spending slumped by 2.2% in the second quarter from a year earlier, although this was offset by a 14.3% jump in exports over the same period.
The latest recession is the first since the Asian financial crisis in 1997-98, from which Hong Kong had not yet fully recovered.
However, financial analysts say there are signs the economy will quickly bounce back.
Travel restrictions imposed during the Sars crisis have been lifted, and there has been an influx of visitors from mainland China.
About 1.3 million people visited Hong Kong in July, up 78% on the previous month.
The government now says the economy should grow by 2% in 2003, after earlier predicting an increase of 1.5%
"We are seeing an upturn at the moment, and the growth rate is much better than we had expected," said government economist Tang Kwong-yiu.
"The Hong Kong economy should continue to pick up in the rest of the year."