Surrounded by failing economies and collapsed currencies, Hong Kong's economy is now faltering and heading towards recession after two decades of robust growth. This pessimistic forecast comes from no less an authority than Hong Kong's Chief Executive, Mr Tung Chee-hwa.

The situation has got to the point where local and international banks are tightening credit to local companies because of massive debt levels in the territory, economists say.

Statistics due out today are expected to show that the economy contracted for the first time in 13 years in the first quarter, underlining the extent of the knock-on effect of the regional economic crisis.

The stock market fell sharply after the blunt-talking Mr Tung shocked Hong Kong by revealing on Wednesday that the once vibrant economy could be facing negative growth. Hong Kong's bluechip Hang Seng Index closed down 1.17 per cent yesterday, following a plunge of 5.26 per cent on Wednesday, reaching its lowest point since January 27th. The bleak economic news puts renewed pressure on the link between the Hong Kong dollar and the US currency.

Hong Kong retailers, hoteliers and exporters say the peg makes the city too expensive for the region. Mr Tung said his administration would not consider changing the exchange rate policy which "will continue to serve us well in the future".

A breaking of the link and the resulting devaluation of the Hong Kong dollar would inevitably force China into a devaluation, which could start a new round of competitive devaluations in the region. Similarly if China devalued, the link would be broken, but Chinese Finance Minister, Mr Xiang Huaicheng, reconfirmed yesterday that China would not devalue.

"We are now in the depth of a major economic adjustment, the result of which may be prolonged and painful to everyone," Mr Tung said at a reception.

"The growth of the economy will fall substantially and indeed may even be negative." He blamed "years of high property prices, high inflation and negative interest rates" which "had created a bubble economy which needed to be corrected if we are to remain competitive".

The administration maintained up until this week that it expected a growth rate of 3.5 per cent for 1998, down from 5.3 per cent last year. This was not likely now, Financial Secretary, Mr Donald Tsang, conceded yesterday. He blamed a deterioration in economic conditions in Hong Kong and the region in recent months. Some analysts expect the contraction to last the whole year.

Mr Shawn Xu, senior economist at Merrill Lynch, said: "This year could see zero or even negative growth. It's very likely. Recovery is not in sight this year." Hong Kong property values are down about 40 per cent since they peaked last year and could plummet further as property developers are holding thousands of empty apartments which they may be forced to sell.

Tourist arrivals fell 22.4 per cent in April compared to a year ago and retail sales in March were down 12 per cent. Gross output fell 6 per cent in 1996 from 1995, confirming the trend of relocation to mainland China. Recently one major European bank wrote to all its clients in Hong Kong including well-established property companies, saying it wanted all its loans repaid in six weeks, according to Regent Fund Management chairman, Mr Peter Everington.

Most of the 800 fund managers who attended a Credit Lyonnais Securities (Asia) forum last week were not in a hurry to invest, chairman Mr Gary Coull said, and more bad news over the coming months would keep investors away.

However, economists insist Hong Kong is unlikely to suffer the fate of South Korea or Indonesia. It has the third-largest reserves in the world, estimated at $145 billion (£102 billion). It is closely tied to the still-growing Chinese economy. It has less exposure to south-east Asia than other economies like Japan and Singapore. It also has a tradition of entrepreneurial flexibility.

But for now the mood is extremely gloomy. Mr Everington said huge deflationary pressures facing the economy would make a break with the dollar inevitable within 18 months, as Hong Kong was still not cheap enough to compete internationally.

"I don't see any economic recovery until 2000, and that's with a devaluation of the dollar," he said.

Mr Bernard O'Sullivan, of GHK Economic and management Consultants in Hong Kong, told The Irish Times: "The pessimists are out in force here in Hong Kong. Some are saying that the HK dollar peg loss is inevitable due to the deflationary pressure that the HK economy is experiencing. Some of the real pessimists are saying that the HK economy is facing a long period of recession even with a devaluation.

"The reality is that for the first three months of this year Hong Kong has recorded negative growth. Corporate profits are falling and a number of key economic sectors like finance and tourism are experiencing serious difficulties," he said.

However, Beijing had been a stabilising factor in refusing to devalue, he said, and the ability of the Hong Kong financial system to absorb the present difficulties had not gone unnoticed.