Facing global economic slowdown, and August’s inflation falling to 4.9%, China’s central bank cut its interest rate first time in six years (from wsj).

A new yardstick for measuring slumps is long overdue

THERE has been a nasty outbreak of R-worditis. Newspapers are full of stories about which of the big economies will be first to dip into recession as a result of the credit crunch. The answer depends largely on what you mean by “recession”. Most economists assume that it implies a fall in real GDP. But this has created a lot of confusion: the standard definition of recession needs rethinking.

In the second quarter of this year, America’s GDP rose at a surprisingly robust annualised rate of 3.3%, while output in the euro area and Japan fell, and Britain’s was flat. Many economists reckon that both Japan and the euro area could see a second quarter of decline in the three months to September. This, according to a widely used rule of thumb, would put them in recession, a fate which America has so far avoided. But on measures other than GDP, America has been the economic laggard over the past year.

To the average person, a large rise in unemployment means a recession. By contrast, the economists’ rule that a recession is defined by two consecutive quarters of falling GDP is silly. If an economy grows by 2% in one quarter and then contracts by 0.5% in each of the next two quarters, it is deemed to be in recession. But if GDP contracts by 2% in one quarter, rises by 0.5% in the next, then falls by 2% in the third, it escapes, even though the economy is obviously weaker. In fact, America’s GDP did not decline for two consecutive quarters during the 2001 recession.

However, it is not just the “two-quarter” rule that is flawed; GDP figures themselves can be misleading. The first problem is that they are subject to large revisions. An analysis by Kevin Daly, an economist at Goldman Sachs, finds that since 1999, America’s quarterly GDP growth has on average been revised down by an annualised 0.4 percentage points between the first and final estimates. In contrast, figures in the euro area and Britain have been revised up by an average of 0.5 percentage points. Indeed, there is good reason to believe that America’s recent growth will be revised down. An alternative measure, gross domestic income (GDI), should, in theory, be identical to GDP. Yet real GDI has risen by a mere 0.1% since the third quarter of 2007, well below the 1% gain in GDP. A study by economists at the Federal Reserve found that GDI is often more reliable than GDP in spotting the start of a recession.

These are good reasons not to place too much weight on GDP in trying to spot recessions or when comparing slowdowns across economies. The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), America’s official arbiter of recessions, instead makes its judgments based on monthly data for industrial production, employment, real income, and wholesale and retail trade. It has not yet decided whether a recession has begun. But even the NBER’s more sophisticated approach is too simplistic in that it defines a recession as an absolute decline in economic activity. This can cause problems when trying to compare the depth of downturns in different cycles or across different countries. Suppose country A has a long-term potential (trend) growth rate of 3% and country B one of only 1.5%, due to slower labour-force growth. Annual GDP growth of 2% will cause unemployment to rise in country A (making it feel like a recession), but to fall in country B. Likewise, if faster productivity growth pushes up a country’s trend rate of growth, as it has in America since the mid-1990s, an economic downturn is less likely to cause an absolute drop in output.

This suggests that it makes more sense to define a recession as a period when growth falls significantly below its potential rate. The IMF estimates that America and Britain have faster trend growth rates than Japan or the euro area. The bottom-right chart shows that since the third quarter of last year, growth has been below trend in all four economies, but Britain, closely followed by America, has seen the biggest drop relative to potential.

But even if this is a better definition of recession, potential growth rates are devilishly hard to measure and revisions to GDP statistics are still a problem. One solution is to pay much more attention to unemployment numbers, which, though not perfect, are generally not subject to revision and are more timely. A rise in unemployment is a good signal that growth has fallen below potential. Better still, it matches the definition of recession that ordinary people use. During the past half-century, whenever America’s unemployment rate has risen by half a percentage point or more the NBER has later (often much later) declared it a recession. European firms are slower at shedding jobs, so unemployment may be a lagging indicator. Even so, the jobless rate has usually started to rise a few months after the start of a recession.

As the old joke goes: when your neighbour loses his job, it is called an economic slowdown. When you lose your job, it is a recession. But when an economist loses his job, it becomes a depression. Economists who ignore the recent rise in unemployment deserve to lose their jobs.

China's Banks Face Hurdles

Benefiting from rip-roaring economic growth and solid loan demand, China's banks have been the envy of their peers the world over. Now that economic growth has moderated, their outsize performance will be hard to sustain.

First-half profits at the nation's top four listed banks — Bank of China, Industrial & Commercial Bank of China, Bank of Communications and China Construction Bank — grew between 38% and 81%. Net interest margins continued to widen, and bad loan levels fell.

Nonperforming loans fell to 6.1% of outstanding loans at major Chinese banks by June's end, compared with 6.7% at the close of 2007, according to the country's banking regulator. In 2002, just before Beijing's last bank bailout, nonperforming loan levels were over 20%.

Of course, that's history.

China's economic growth rate is slipping, taking corporate performance with it. Overall profit growth for 1,619 mainland-listed companies rose 16% in the first half, compared with a 49% rise in 2007, according to JPMorgan figures.

Evidence of a slowdown in the property sector has some worried. Real estate sales were down 20% on the year in July, for example.

As growth slows, the banks' outlook will depend largely on how disciplined they've been about managing credit risk. This hasn't been tested since the government's 2003 bad-loan bailout.

Loan growth since then — of more than 13% in each of the last two years — has given Chinese banks among the most unseasoned collective loan books in Asia. There's little data history for banks to stress-test their books effectively.

What can be said is there are few signs the banks have excessive exposure to deteriorating asset quality in one or another problematic sectors, whether real estate or export-focused manufacturers.

It's particularly true of the property sector. Commercial bank mortgage lending was around 11% of total loans at the end of 2007, while lending to property developers was 7% — a total exposure of 18%. In the U.S., the comparable total figure was 53%, according to Goldman Sachs.

So even if this won't be anything like the crisis conditions afflicting Western peers, declining performance is likely.

With Buybacks, Look Before You Leap

Repurchases Routinely Give Shares a Lift,
But the Effect Could Be Ephemeral

Buying high and selling low: That sounds dumb. But call it a "share repurchase program" (or stock buyback), and people get excited.

Stocks regularly jump up 3% to 6% on the announcement of a buyback, and it's easy to see why they should.

Done right, buybacks are a boon. They reduce the number of shares outstanding, spreading the company's future profits over a smaller base — thus increasing earnings per share. Over time, firms that repurchase their shares have beaten the market by about three percentage points a year. Unlike dividends, buybacks generate no tax bills for ongoing shareholders.

Above all, share repurchases prevent cash from burning a hole in management's pocket. Long ago, Benjamin Graham pointed out a paradox: The better a company's executives are at managing its businesses, the worse they are likely to be at managing its cash. Great businesses produce piles of wampum — and, to management, idle cash is the devil's workshop.

Three decades ago, with oil skyrocketing and profits gushing in, energy companies squandered billions of dollars on one bone-headed diversification after another. Mobil bought Montgomery Ward, the dying retailer. Arco acquired Anaconda Copper just before metal prices collapsed. Exxon even got the bright idea of manufacturing typewriters.

In the latest oil boom, the energy giants have favored buybacks over misbegotten empire building. So far in 2008, ConocoPhillips has spent $5 billion buying back stock; Chevron, $3.6 billion. From the end of 2004 through this June 30, says analyst Howard Silverblatt of Standard & Poor's, Exxon Mobil has soaked up an astounding $102.2 billion worth of its own shares.

Big oil is not alone. All told, the companies in the Standard & Poor's 500-stock index have bought back shares valued at more than a half-trillion dollars' worth of their shares in the past year.

Unfortunately, firms don't always buy stock back when it is cheap. In fact, you would have an easier time teaching a platypus to play the clavichord than getting a manager to admit his stock is overpriced. Every three months, Duke University economist John Graham surveys hundreds of chief financial officers. During the week of March 13, 2000, the absolute peak of the market bubble, 82% of finance chiefs said their shares were cheap, with only 3.4% saying their stock was "overvalued." More recently, buybacks hit their all-time quarterly high of $171.9 billion in September 2007, just before the Dow crested at 14000.

Mistimed buybacks can be deadly. In 2006 and 2007, Washington Mutual spent $6.5 billion on buybacks. In January 2007, with the stock at 43.73 per share, chief executive Kerry Killinger called the repurchase program "a superior use of capital." Also in 2006 and 2007, Wachovia sank $5.7 billion into buybacks at an average price of more than 54. Citigroup spent $8.3 billion to repurchase stock in 2006 and 2007 at share prices of about 50. In April 2008, all three banks were so capital-starved that they had to raise cash by selling shares for a fraction of what they had recently paid for them — WaMu at 8.75, Wachovia at 24, Citi at 25.27 a share.

Another warning: Contrary to popular belief, buying back stock isn't like canceling a postage stamp. Rather than being "retired," most repurchased shares sit in the corporate treasury — and they can be yanked back out for just about any reason.

Look again at Exxon Mobil, which has repurchased 2.8 billion shares, carried on its books at their cost of $131 billion. But their current market value is $229 billion. If ExxonMobil decided to get into, say, the soap and diaper business, it could buy all of Procter & Gamble, the fifth-biggest stock in America, and have $10 billion in stock left over.

No, I don't believe Exxon Mobil is about to do anything that dumb. But less canny outfits could — and will. Buy into a company that doesn't retire shares after it repurchases them and you are playing with fire.

Back in 1999 and 2000, tech companies wildly overpaid to buy back stock, while stodgier firms like Philip Morris repurchased shares dirt cheap. A buyback probably makes sense if the stock is less than its average price/earnings ratio of the past five years.

Finally, the historical outperformance of buybacks comes from an era when not everybody was doing them. From now on, long-term returns are bound to be lower. Before you invest, ask whether the stock would look cheap even without the buyback. It's hard enough to avoid buying high and selling low on your own account. Why run the risk that someone else will do it for you?