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Chapter 5. Issues of Special Interest to the Middle East and North Africa

Author(s):
Carlo Sdralevich, Randa Sab, Younes Zouhar, and Giorgia Albertin
Published Date:
July 2014
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This chapter will cover topics of particular importance to the Middle East and North Africa (MENA), based on recent reform experiences: best practices in social safety nets, impact of subsidy removal on the macro economy and productive sectors, and the political economy of subsidy reform.

Social Safety Nets

Countries in the MENA region have historically relied heavily on food and fuel price subsidies as a form of social protection, rather than on social safety net instruments and social insurance. Cash transfers and other forms of direct income support are not used widely and, where they exist, are generally underfunded. A recent World Bank study found that social safety nets (excluding subsidies) in the region attract public resources equivalent to less than 0.7 percent of GDP on average.1 These are fragmented among several small programs with large overlaps, and suffer from high leakages. The study also found that the average social safety net program (excluding subsidies) in MENA allocates only 23 percent of its total benefits to the bottom quintile, against 59 percent in Latin America and the Caribbean and in Eastern Europe and Central Asia. The social safety net programs in MENA have limited impact on poverty and inequality because of low coverage, inefficient targeting, and poor or absent monitoring and evaluation systems.

As a result, governments in MENA tend to cope with crises by scaling up subsidies or increasing public sector employment. This is also the experience of the Arab Spring, when several MENA countries expanded subsidies or reduced taxes on food and fuel products to address social demand at a time of high commodity prices.2 Those countries in the region with social safety net programs—such as cash transfers—were able to scale these up.

But, as discussed in Chapter 2, generalized price subsidies do not target those in most need, strain public finances, and foster overconsumption, particularly of energy. Social safety nets, including targeted price subsidies, are better at supporting poor households. Social safety nets are also more cost-effective, and thus leave more fiscal resources for other priority spending, such as investment in infrastructure, education, and health, which also benefit populations at large.3 World Bank and IMF work confirms these advantages:

  • World Bank simulations in a computable general equilibrium model showed that poverty in Egypt could be cut by one-third if energy subsidies were reduced by 50 percent and the savings distributed uniformly in cash to the population (a targeted transfer would reduce poverty even more);4 and
  • Similarly, IMF staff simulations in 2011 for Jordan showed that a gradual elimination of price subsidies on energy products, bread, and water, and replacement through a well-targeted cash transfer system could improve the welfare of the poorest 40 percent of the population, while producing fiscal savings of 5 percent of GDP.

Improving Targeting

Targeting public interventions is key to providing cost-effective social protection for the poor and vulnerable. Proper targeting helps direct resources to the envisaged beneficiaries by reducing errors of exclusion (cases of intended recipients who do not get the benefit) and errors of inclusion (cases of unintended recipients who do get the benefit).

  • Lebanon launched a central targeting program in 2009 (National Poverty Targeting Program) building the basis for an effective social safety net.5 The National Poverty Targeting Program provides a basket of benefits including partial medical bill payment, school fee waiver, and free books.

Ideally, governments should target social protection programs to the neediest through effective means testing. Means tests use income or poverty thresholds to determine benefit eligibility, and should normally be designed to phase out benefits gradually as income rises, to reduce disincentives for seeking work. Well-implemented means tests have been shown to deliver good results in minimizing targeting errors; however, they require significant administrative capacity and good-quality data (including data from poverty and consumption surveys), and are thus quite costly.6 Where means testing is not practical, other targeting methods can be used that demand less administrative capacity and data. Alternative methods include proxy means tests (beneficiary selection based on easy-to-observe household characteristics such as quality of housing and/or ownership of durable goods), categorical targeting methods (beneficiary selection based on location or demographic attributes such as age or gender), and self-targeting (free access is given to a benefit, but design features provide incentives ensuring that a substantial portion of the benefit reaches the target population):

  • Yemen reformed its Social Welfare Fund, its main cash transfer program, by improving poverty targeting with a proxy means-test formula, strengthening capacity for service delivery, and adopting a new legal policy framework.7

Self-targeting has been adopted by a number of countries in the MENA region for food products and—to a lesser extent—for fuels:8

  • In Tunisia in the early 1990s, the authorities were able to improve the targeting performance of food subsidies in part by using differentiated (less attractive) packaging, including selling certain products such as cooking oil from bulk containers;9 and
  • In several countries, including Morocco and Egypt, higher octane fuel used predominantly by more expensive cars and sport utility vehicles is less subsidized than diesel fuel used in public transport.

Another approach to limiting benefit leakages is keeping the amount of subsidized product below a certain threshold corresponding to the service or product volumes usually consumed by the poor:

  • Many countries, such as Jordan and Egypt, provide cheap electricity to households for consumption up to a certain threshold (so-called lifeline tariffs);
  • In Iran, the electronic card system introduced in June 2007 for gasoline rationing and quotas also provided a de facto multi-tier energy pricing structure for gasoline. This structure introduced an element of gradualism in the reform, while accomplishing the main objective of increasing “free market” prices. The subsidized price of rationed gasoline was increased but remained well below the full price at which consumers could purchase an unlimited amount of fuel. Rationing also required the implementation of a comprehensive vehicle registration system and personalized distribution and management of the gasoline quotas;10 and
  • In Egypt, subsidized food is provided in limited quantities through ration cards/coupons, although the latter are widely used (by almost 68 percent of households in Egypt). Similarly, in Jordan, where subsidized food is provided in limited quantities through ration cards and/or coupons, the government is planning to review the general food subsidy on wheat flour in the course of 2014 to prevent abuse.

Cash Transfers

Even with some form of targeting, price subsidies tend to be less cost-effective and incentive-compatible than other safety net instruments. In particular, self-targeted food subsidies rarely perform better than a uniform cash handout. Similarly, rationing strategies such as lifeline tariffs have been shown to have a relatively poor targeting performance, because of the low access to electricity among the most vulnerable. Moreover, these targeting mechanisms do not remove the price distortions created by subsidies; hence, incentives for waste and smuggling remain—albeit to a lesser degree if access to subsidized goods is rationed.

Cash or near-cash transfers, especially when means-tested, offer a number of advantages over subsidies as a social protection instrument.11, 12 They do not directly distort prices, provide flexibility and more choice to recipients, have a relatively low administrative cost once the infrastructure has been set up, and can be easily scaled up in case of need (for example, in crises). IMF estimates indicate that well-designed cash transfer systems in MENA can typically result in about 50–75 percent of spending reaching the bottom 40 percent of the population, compared with 20 percent of the amount spent to subsidize fuel prices and 35 percent to subsidize food prices.13 Several MENA countries have had successful experiences with the adoption of cash transfers (Box 5.1).

Cash transfers can be made conditional on recipient households taking human capital–enhancing actions such as sending children to school or receiving immunizations.14 Though more complex to administer than unconditional transfers, conditional cash transfers can provide additional incentives for households to take actions that can help increase their future earnings potential and reduce the intergenerational transmission of poverty.

Box 5.1.Examples of Successful Cash Transfers in the Middle East and North Africa1

Iran: In December 2010, Iran cut indirect subsidies and put in place an across-the-board cash transfer program for households. In advance of the price adjustments, the authorities deposited cash transfers in new bank accounts for households, which were to be financed by the revenue from price increases. The cash was released with the launch of the reform.

Jordan: The National Aid Fund was established in 1986 as a means-tested program. The recurrent cash assistance program, providing cash support to the poor and vulnerable, is the largest program administered by the National Aid Fund in terms of scope. The fund provides the beneficiaries with monthly cash transfers ranging from JD 40 (US$56) to JD 180 (US$254) depending on income. It also provides emergency assistance, disability and health benefits, and vocational training.

Mauritania: With the assistance of the World Food Program, the government has launched a cash transfer program targeting 10,000 vulnerable households in Nouakchott identified through a poverty survey. Each household receives UM 15,000 monthly or about US$51 (equivalent to half of the legal minimum wage) via a bank transfer.

Morocco: The conditional cash transfer pilot program to encourage education in underprivileged areas was launched in the second half of 2007. The direct transfers to households are conditioned on the children regularly attending primary school. The pilot program reaches more than 160,000 households and nearly 300,000 students.

Yemen: The Social Welfare Fund was established in 1996 as a poverty alleviation program to provide conditional cash transfers to more than 1.5 million households. The coverage of the fund as well as the transfers has been gradually increased. The transfers were partly meant to mitigate the impact of fuel subsidy reforms.

1Clements and others (2013), Silva, Levin, and Morgandi (2012), and International Labor Organization Social Security Inquiry database.

Cash and in-kind benefits can normally be delivered to beneficiaries using one of two main methods. The first method requires that the distributing agencies directly distribute cash or in-kind benefits. The second one involves giving the beneficiaries access to the benefits through checks, vouchers, direct deposits, smart cards, cell phones, and the like that can be redeemed at one of the distributing agencies. Money transferred electronically to beneficiaries has the potential to cut costs, reduce leakages, promote access to financial services, and provide better security compared to physically delivering cash. But the lack of regulatory and financial infrastructure in low-income countries means that e-payment systems need substantial up-front investment.15

Cash transfers do suffer from some drawbacks. The main issues arise from implementation. Cash transfers (even if uniform, but particularly if conditional) require a fairly precise census of individuals and households and simple but sound methodologies to verify that conditions have been satisfied. Furthermore, when governance is weak, cash transfers open the way to abuse by making it easier to channel public resources to unintended beneficiaries, for example, to obtain political support. Lastly, cash transfers may create disincentives to work for recipients.

Macroeconomic Impact of Subsidy Reform

Inflationary Effects

Food and fuel subsidy reform may translate into an increase in inflationary pressures if price increases are large enough. The hike in previously subsidized prices will cause a first-round increase in food and/or fuel inflation, with the magnitude of the pass-through dependent on the weights of food and fuel products in the consumer price index. The price dynamics will also be affected by the second-round impact on core inflation (nonfood and fuel prices), which depends on expectations of future inflation and the presence of indexation mechanisms in the economy (particularly if based on the overall price index). Empirical evidence from a sample of countries has pointed out that hikes in food prices have higher second-round effects on inflation than hikes in fuel prices.16 This difference may reflect the large weight of food products in the consumer basket, resulting in higher impact on real household incomes and therefore stronger wage pressures. However, the difference in impact between food and fuel prices may not always hold in the case of subsidy removal, because price increases taking place in the context of subsidy reform may be limited to a relatively narrow range of food products and may therefore have a more limited impact on household incomes.

In line with the standard recommendations on the response to price shocks, the first-round impact should be accommodated, since it is a one-off shock that reflects the realignment of relative prices following the removal of the policy-induced distortions represented by subsidies. Monetary policy should accommodate this realignment and allow the pass-through of higher food and fuel prices to inflation. This policy stance would avoid the output loss resulting from the mistaken tightening of monetary policy in response to a temporary inflationary shock. The policy-driven nature of the first-round increase in prices should also make it easier for the central bank to single out the temporary component among other possible inflation pressures. In parallel, the government should address the erosion of poor households’ real incomes caused by the first-round inflation push, by introducing or strengthening social safety nets.

Monetary policy should, however, respond to second-round effects. If inflation expectations and indexation mechanisms play an important role in the economy, the central bank should focus on noncore inflation to judge whether a tightening of policy is needed to stifle a wage-price spiral. Prompt policy reaction would be particularly important for countries where inflation was already on the rise before the implementation of the subsidy reform.

A strong anti-inflationary stance before the launch of subsidy reform can help contain second-round effects. Tight monetary policy in advance of reform can anchor the public’s inflationary expectations.

  • In Tunisia, the increase in inflation from 5.1 percent in January 2012 to 6.4 percent in April 2013 is mainly explained by higher food and energy prices. For energy products, all of the increases reflected recent rises in administered prices of petroleum products and energy tariffs, while food price rises reflected increases in nonadministered prices.
  • In Mauritania, inflation fell from 5.5 percent at end-2011 to 3.4 percent at end-2012, significantly lower than projected, as the regular increases in retail fuel prices were more than offset by the decline in food prices (which make up 49 percent of the consumption basket).

Macrofiscal Impact

In the long term, subsidy reform has a positive effect on growth, thanks to the elimination of distortions, the rationalization of energy use, the increase in export revenues in oil exporters, the enhanced competitiveness, and a stronger budget structure.17 However, in the short term, the removal of subsidies is equivalent to a reduction in current public spending and can have a contractionary effect if it produces net budgetary savings, assuming a positive fiscal multiplier in line with the findings of empirical analysis for developing countries.18 Recent IMF work shows that fiscal multipliers may be higher in recessionary environments; these results suggest that subsidy reform can be less “growth-damaging” if undertaken when the economy is doing well. Furthermore, the dampening effect on growth can be minimized to the extent that all or part of the savings are redirected to other public spending, especially transfers to the poor (who have a very high propensity to consume) and investment (which generally has a high multiplier). These demand considerations provide an additional argument in favor of introducing compensating measures concurrently with the elimination of subsidies:

  • According to a study conducted by Morocco’s State Planning Agency, the increase in energy prices in September 2013 may cut economic growth by 0.2 percent in 2013 and 0.5 percent in 2014 by slowing domestic demand. Overall, reducing subsidies for energy products is expected to improve the budget deficit by 0.2 percent of GDP in 2013 and 0.6 percent in 2014, but it would hike domestic consumer prices by 0.4 percent in 2013 and 1.1 percent in 2014. The estimates assume that no measures would be put in place to counter the rise in costs.19

Impact on the Productive Sector

The removal of subsidies—particularly those on fuel—represents a negative shock for the productive sector. A fuel price hike effectively amounts to an increase in indirect taxation on enterprises’ inputs. The increase in enterprises’ production costs depends at the individual level on the goods and services produced and on the production function. The impact at the aggregate level is related to the economy’s energy intensity and its openness to external competition and markets. Examples of energy-intensive industries are aluminum, metal casting, chemicals, mining, forest products, petroleum refining, glass, and steel.20 The increase in energy prices can also have significant second-round effects on less energy-intensive sectors, such as agriculture. For example, higher fuel prices could push up the cost of water and fertilizers, and, in turn, reduce agricultural revenues, with important social implications for small farmers—who may not be able to pass the higher cost to consumers—in the absence of compensating measures.

In most MENA countries where fuel subsidies are very large, the economy is generally much more energy-intensive, and the increase in prices triggered by subsidy reform would have a bigger impact than it would have in economies that have already adapted to the high oil prices of recent years (Figure 5.1 and Box 5.2).21

Figure 5.1.Energy Intensity by Country, 2000 and 2010

(In kg of oil equivalent/PPP GDP)

Sources: World Bank, World Development Indicators database; and IMF staff calculations.

Note: PPP = purchasing power parity.

Export-oriented industries are likely to be particularly affected by subsidy reform. The increase in input costs translates into smaller profits (and possibly bankruptcy and exit from the market) unless firms are able to pass on the increases to final consumers. This is likely to be more challenging for industries that are export-oriented or face competition from imports, and therefore are price-takers. For those sectors that are more oriented toward domestic consumption and captive markets, the rise in costs will lead to an increase of product prices that can be, at least in part, absorbed by the final consumer. Overall, the change in relative prices will lead to a shift in the production mix away from energy-intensive goods.

  • In Jordan, electricity tariffs increased for selected service and manufacturing companies in June 2012. The impact is estimated to have been stronger for energy-intensive sectors such as the phosphate industry, but relatively limited for the less energy-intensive light industry, which makes up for the bulk of nonprimary exports. However, the negative impact on external competitiveness must be seen in the perspective of better provision of electricity in Jordan compared to neighboring countries, where the unreliability of the electricity network forces operators to rely on expensive private generators. Moreover, to reduce dependence on energy imports, other energy sources, with lower generation costs, are being developed.
  • Industrial tariffs for gas in Bahrain were increased by 50 percent on January 1, 2012, with an annual estimated savings of 1.4 percentage points of GDP. This mostly affected Bahrain’s aluminum industry, which comprises the bulk of the country’s manufacturing sector. However, the aluminum industry continues to be profitable and competitive, because of the still relatively low prices of gas.

Box 5.2.Egypt: Adverse Consequences of Subsidies—High Energy Intensity Industries and Shortages

Impact on the productive sector: In addition to subsidizing motor fuel and liquid petroleum gas (LPG) for general consumption, Egypt has for decades provided a generous subsidy scheme for industrial use. In 2011, natural gas and fuel oil were available for Egyptian companies at less than 40 percent of the cost recovery price. This has resulted in distortions, generating a bias in favor of capital- and energy-intensive industries that encourages diversion of resources—including foreign direct investment—to these sectors, to the detriment of more energy-efficient or labor-intensive industries. As a result:

  • Egypt exports less textile and garment products than Tunisia and Morocco despite significantly lower wages. At the same time, Egypt’s exports from its high energy-intensive sectors have increased significantly. Egypt has become a significant exporter of cement and ceramics, despite the associated high shipping costs; and
  • Even excluding the energy sector, almost 50 percent of the manufacturing sector is composed of high energy-intensive industries; 15 percent represents low energy-intensive industries, and the rest are medium energy-intensive industries.

Shortages of subsidized products: Generous subsidies encourage excessive consumption and entail a prominent government role in the distribution of subsidized products, exacerbating existing distortions. In Egypt, 60 percent of gas stations and most of the LPG cylinder deposits and distribution centers are publicly managed. State-owned enterprises’ lack of optimal distribution strategy and inefficiencies and mismanagement, combined with excess demand, have in recent years pushed retail prices of LPG cylinders to six times the official price, defeating the purpose of the subsidy policy and hurting mainly the poor households that are likely to suffer from the diversion of supply to wealthy neighborhoods.

In designing fuel subsidy reform, the government should consider the impact on the productive sector and could introduce temporary relief measures. Firm commitment to phasing out these measures is, however, essential to avoid replacing the distortions deriving from subsidies with other types of distortion.

  • In Iran, 20 percent of the revenue from the end-2010 price increases was to be set aside to provide support for enterprise restructuring and for efforts to reduce energy intensity. The authorities conducted a review of more than 12,000 enterprises along several criteria to assess the various channels through which the reform could affect them. Out of these enterprises, 7,000 were selected to receive some form of targeted assistance to restructure their operations. This included direct assistance as well as sales of limited quantities of fuels at partially subsidized rates to moderate the impact of the price increase on the input costs of enterprises in the industrial and agricultural sectors.22 However, assistance to enterprises remained very limited during the implementation of the reform.
  • Many industries in Yemen are highly dependent on subsidized energy products. Energy intensity, both direct and indirect as measured through the input-output matrix, is highest in electricity production, oil refining, light manufacturing, and water.

The first-best approach to helping firms absorb the impact of higher input prices consists in improving the economy’s competitiveness by improving the business climate and promoting corporate restructuring, helping the economy adapt to higher energy prices (including measures to support energy efficiency and public transportation), and training workers who exit industrial sectors that are no longer competitive.

To encourage enterprises—especially if state-owned—to adapt to the new, tougher environment, it is crucial that the government take a firm stance to squash expectations of bailouts, which could end up costing more than the gains from the subsidy reform. The removal of subsidies will help industries pursue strategies to minimize energy costs, making it more efficient, and strengthen incentives for research and development in energy-saving and alternative technologies.23

In addition, the removal of subsidies should eliminate price distortions and result in a better allocation of resources toward investment that would be more profitable in the absence of subsidies.

Elimination of the artificial competitive advantage deriving from subsidies would also improve the weak corporate governance of state-owned hydrocarbon enterprises. To facilitate restructuring, the government may also want to phase in gradually—following a credible, preannounced path—the removal of subsidies, so that firms have time to restructure and prepare for the input cost shock.

Managing the Political Economy of Subsidy Reform

Political economy factors often derail subsidy reforms, even if their design is sound from an economic and equity perspective. Resistance to change from society and the political system can block a reform, independently of its rationale, benefits, and urgency. A number of factors make subsidy reforms particularly vulnerable to such pushback:

Political mobilization bias: The beneficiaries of subsidy reform, generally the poorer households, are often less organized and politically enfranchised than those who would be worse off, such as the middle class (typically, car owners, in the case of fuel subsidies) and vested corporate interests (for example, the transport sector or energy-intensive domestic producers).

Lags in the timing of costs and benefits: The impact of eliminating price subsidies is, in most cases, felt immediately. But effective subsidy reform takes time to implement, and its benefits often become visible only with a lag. For example, savings from subsidy reform that are used to increase investment in health or education will take years to produce measurable improvements. This lag time increases the likelihood of an early buildup of opposition to reform. Also, reform will be resisted when there is little confidence in the government’s capacity to put the savings from subsidy reform to good use. The lag time between subsidy removal and benefits is particularly harmful when there is little trust between citizens and the state, as is often the case in the MENA region—which makes subsidies so attractive in the citizens’ eyes; they are a clear and easy-to-implement benefit from the state.

Weak administrative capacity of governments: Subsidy reform requires relatively strong administrative capacity—not so much for the removal of price subsidies, which is relatively easy, but more for the design and implementation of some supporting measures, such as the introduction of well-targeted social safety nets and other compensating measures, or the launch of an effective communication campaign.

Long duration of the reform effort: While gradualism can help reduce adjustment costs and thereby lessen resistance to reform, price subsidy reforms that involve several steps and spread over several years are more exposed to resistance from vested interests, who may use the time to coordinate and solidify into a blocking coalition that can effectively veto the reform. Moreover, lengthy reforms are vulnerable to cyclical developments (such as an economic downturn or approaching elections) or unexpected shocks (such as sharp commodity price increases or natural disasters) that may create resistance to implementing the reforms as originally planned.

Designing Political Economy-Robust Reforms

Policymakers should anticipate the role of political economy factors and take possible obstacles into account when designing subsidy reforms. A number of measures can be taken to make price subsidy reforms more robust:24

Build an objective case for reform: Public perceptions are influenced by the weight of compelling evidence and arguments that demonstrate the benefits of reform and shape a positive narrative in favor of it. Producing such evidence may require strengthening the measurement systems of the social and poverty impact of price subsidies, preferably before the launch of the reform. Poverty surveys and independent studies from a variety of sources, including international organizations, can show the drawbacks of price subsidies and the benefits of reform.

Increase transparency and the implementation capacity of the state: Governments can greatly strengthen the case for reform by increasing the transparency of how public resources are used in relation to the composition of subsidized prices (which is relatively easy to do for fuel products, by breaking down the composition of subsidized prices). Where there is mistrust in a government’s ability to use subsidy savings appropriately, earmarking can be used to ensure that resources are allocated to desirable uses.

Earmarking of resources should, however, be used sparingly because it introduces rigidity into the budget that is not desirable from the perspective of public financial management. The credibility of reform can also be strengthened by tasking new or restructured institutions with the implementation of the various components of the reform (e.g., independent agencies to set prices based on objective assessment, and social agencies to plan and administer the social safety nets). Partly because of the natural dynamics of bureaucracies, an appropriate institutional framework can support and defend the reform, making it irreversible even in the face of strong resistance.

Create public concern through a communication campaign that starts well in advance of the reform: Leveraging improvements in transparency on subsidy systems, communications should focus on the costs of subsidies, stress the benefits of alternative policies, and offer comparisons with peer countries.

Create coalitions of stakeholders who would benefit from reforms to balance the resistance of vested interests: For example, authorities can disclose target groups and beneficiaries of social programs that will be scaled up (such as cash transfers) and mobilize them so they can have a voice. Similarly, the authorities can take measures to ease the resistance of middle class households, for whom price subsidies are often the only tangible benefit received from the government. Gradualism in the adjustment, as well as credible commitments to reinvest savings in improving the quality of public services, especially education and health, may help achieve this objective.

Leverage the regional dimension of subsidy reform: Coordinating reforms across neighboring countries can help contain cross-border arbitrage and smuggling, especially on fuels, due to cross-border price differentials. This, in turn, can help contain corruption and the entrenchment of vested interests. In addition, regional coordination could help countries learn from others about the reform process, particularly when they share similar economic structures.

Embed subsidy reform in a wider policy reform plan: Public support can be easier to create if subsidy reform is part of a wider reform plan that enjoys broad popularity. For example, if there is a broad societal consensus and pressure for education or health reform, subsidy reform can explicitly be linked to funding of health reform. This may reduce resistance as the failure to reduce subsidies would derail other highly desired policies.

2For a full set of measures undertaken since late 2010 in the MENA region, see IMF (2011).
11Near-cash transfers include coupons/vouchers that may be used to purchase food or other essential goods and services. Income support can also be provided through public works programs.
14Successful programs in this area include Bolsa Familia (Family Grant) in Brazil and Oportunidades (Education, Health, and Employment Program) in Mexico. For further discussion of conditional cash transfer programs, see Grosh and others (2008).

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