Abstract

21. Major fiscal consolidation will be needed over the years ahead. The increase in budget deficits played a key role in staving off an economic catastrophe. As economic conditions improve, the attention of policymakers should now turn to ensuring that doubts about fiscal solvency do not become the cause of a new loss of confidence: recent developments in Europe have clearly indicated that this risk cannot be ignored. A distinct, but equally important risk to be averted is that the accumulated public debt, even if does not result in overt debt crises, becomes a burden that slows long-term potential growth. This section looks at fiscal strategies to address these risks, focusing on the goals of fiscal policy in the years ahead. The next section looks at specific measures and institutional reforms to achieve needed adjustment.

21. Major fiscal consolidation will be needed over the years ahead. The increase in budget deficits played a key role in staving off an economic catastrophe. As economic conditions improve, the attention of policymakers should now turn to ensuring that doubts about fiscal solvency do not become the cause of a new loss of confidence: recent developments in Europe have clearly indicated that this risk cannot be ignored. A distinct, but equally important risk to be averted is that the accumulated public debt, even if does not result in overt debt crises, becomes a burden that slows long-term potential growth. This section looks at fiscal strategies to address these risks, focusing on the goals of fiscal policy in the years ahead. The next section looks at specific measures and institutional reforms to achieve needed adjustment.

A. Debt Stabilization Strategy and Associated Fiscal Adjustment

22. As discussed in the November 2009 Monitor, countries will need to make a key strategic decision whether to stabilize public debt at post-crisis levels or to bring it down. Earlier projections indicated that lowering the gross general government debt-to-GDP ratio back to 60 percent for advanced economies by 203015—the pre-crisis median—would require improving the CA primary balance by 8 percentage points of GDP.16 Owing to the weakening of CA positions discussed in Section I, the required adjustment is now projected at 8.7 percentage points, from a projected deficit of 4.9 percent in 2010 to a surplus of 3.8 percent of GDP in 2020 (Figure 11 and Table 1 in Appendix 2).17 For emerging economies, using a similar methodology but assuming a lower debt target (40 percent, a threshold beyond which fiscal risks are often considered to rise in emerging economies), the adjustment averages 2.7 percentage points of GDP, confirming that fiscal policy challenges are more modest for these countries (Table 2 in Appendix 2).

Figure 11.
Figure 11.

Advanced and Emerging Economies: Illustrative Scenario for Fiscal Adjustment

(In percent of GDP)

Sources: April 2010 WEO and IMF staff estimates.Notes: For advanced economies, all concepts of fiscal balance exclude losses from financial sector support measures. CA balances are reported in percent of nominal GDP. In this scenario, the CA primary balance (CAPB) is assumed to improve gradually from 2011 to 2020; thereafter, the CAPB is maintained constant until 2030. The CAPB path is set to stabilize a country’s debt-to-GDP ratio at its end-2012 level by 2030 if this is less than 60 percent (40 percent for emerging economies); otherwise, it is set to reduce the debt-to-GDP ratio to 60 percent (40 percent for emerging economies) by 2030. The analysis is illustrative and makes some simplifying assumptions: in particular, up to 2015, a zero interest rate-growth rate differential is assumed, broadly in line with WEO assumptions, and 1 percentage point afterward regardless of country-specific circumstances. For Japan, a gross debt target of 200 percent of GDP (net debt target of 80 percent of GDP) is assumed. For Norway and Saudi Arabia, maintenance of primary surpluses at the projected 2012 level is assumed.

23. Given the significant required adjustment in the above scenario for advanced economies, less ambitious debt targets could be considered, but this could have important implications for economic performance. In addition to more limited fiscal space to respond to economic shocks, higher debt levels are likely to be accompanied by higher interest rates and lower potential growth. More specifically:

  • The November Monitor presented econometric results showing that a 10 percentage point increase in the debt ratio is likely to lead to an increase in long-term real interest rates of around 50 basis points over the medium run.18 Given the average increase in debt ratios in advanced economies, this suggests that interest rates could increase by almost 2 percentage points over the medium term (with respect to a scenario of stabilization at precrisis level).19 Such an increase in interest rates for advanced economies would also adversely affect emerging economy financing conditions.20

  • New econometric evidence on the impact of high debt on potential growth—based on a panel of advanced and emerging economies over almost four decades—shows an inverse relationship between initial debt and subsequent growth, controlling for other determinants of growth (Appendix 3). Estimates based on a range of econometric techniques suggest that, on average, a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year, with the impact being smaller (around 0.15) in advanced economies.21 There is some evidence of nonlinearity, with only medium (30 to 60 percent of GDP) to high (above 90 percent) levels of debt having a significant negative effect on growth. This adverse effect largely reflects a slowdown in labor productivity growth, mainly due to reduced investment and slower growth of the capital stock. On average, a 10 percentage point increase in initial debt is associated with a decline of investment by about 0.4 percentage points of GDP, with a larger impact in emerging economies. To some extent, higher initial debt is also associated with higher macroeconomic volatility, and with lower total factor productivity growth.

24. Taking into account the impact of high debt on interest rates and potential growth, a strategy of debt stabilization at post-crisis levels is less appealing. The increase in the primary balance needed to stabilize or lower the debt ratio depends on the interest rate (r) − growth (g) differential (“r − g”). The larger the differential, the larger the increase in the primary balance needed to stabilize or lower the debt ratio. In Figure 12, the relationship between a particular debt reduction target and the needed fiscal adjustment needed is shown as the line “r − g=1,” under the assumption that the differential (1 percentage point, as in Figure 11) is unaffected by the debt level. As noted, the goal of reducing the debt ratio below 60 percent by 2030 requires an average improvement in the CA primary balance by 8.7 percentage points of GDP, while stabilizing the debt ratio at its postcrisis level would require a smaller—albeit still sizable—improvement (about 6.5 percentage points of GDP). However, the trade-off is much less favorable if the differential is influenced by the target level of debt. This is shown in the line of Figure 12 labeled “Endogenous r − g from 1 to 3,” which assumes that the interest rate-growth differential increases linearly from 1 to 3 percentage points as the average debt ratio rises from 60 to 100 percent of GDP.22

Figure 12.
Figure 12.

Advanced Economies: Illustrative Fiscal Adjustment Need as Function of Debt Target and Interest Rate-Growth Differential

Source: IMF staff estimates based on the April 2010 WEO.Notes: The baseline simulation with a constant interest rate-growth differential r-g of 1 percentage point is similar to the illustrative fiscal adjustment scenario depicted in Figure 11, with the only difference that low-debt countries are assumed to stabilize their 2015 debt level (2012 in the illustrative scenario) as a proxy for the postcrisis debt level. The simulations here vary the debt target. The starting point is a target of 60 percent of GDP (200 percent of GDP in the case of Japan). The debt target is then incrementally increased, with average long-run debt ratios rising to approximately 100 percent of GDP. The two alternative simulations allow for the possibility that interest rates rise and growth rates decline as debt ratios increase. Specifically, they model this differential as a linear function of the long-run average debt ratios, bounded by 1 percentage point at the lower end for average debt ratios below 60 percent of GDP and either 2 or 3 percentage points at the upper end for an average long-run debt ratio of 100 percent.

25. If governments fail to signal a credible commitment to reduce debt ratios, the resulting increase in interest rates (and decline in growth rates) could increase the required effort markedly. Indeed, it would warrant a fiscal effort merely to stabilize debt ratios at their postcrisis levels that is almost as large as what would have been required to reduce the debt ratio had interest rates remained at more moderate levels. This underscores the importance of early actions to demonstrate a commitment to lower debt ratios. A more optimistic alternative scenario limits the increase in the interest rate-growth differential to 2 percentage points, but even in this scenario about half of the fiscal adjustment gains with a constant interest rate-growth differential of 1 percentage point are lost to more adverse debt dynamics.

26. The extent of fiscal adjustment required to achieve certain debt targets varies significantly across advanced economies.

  • The adjustment is highest—close to or above 10 percent of GDP in the baseline scenario described above—in countries with high initial CA primary deficit and debt levels (Greece, Ireland, Japan, Spain, the United Kingdom, and the United States) (Figure 13 and Appendix 2).

  • Greater adjustment need also reflects larger deterioration of CA primary balances during the crisis—for example, in Germany—compared to other countries where initial debt ratios were higher but changes in balances were more limited—for example, Italy. More generally, even countries with low debt would have to adjust to eliminate the primary imbalances existing in 2010. Some countries (e.g., Australia) would have to adjust not because debt levels are higher than the threshold, but because running primary deficits would prevent debt stabilization at any level.

  • As noted above, the size of the adjustment depends on the assumed interest rate-growth differentials. Figure 13, top panel, refers to a uniform r − g differential across all countries, which could be plausible if all countries adopt credible adjustment strategies, and (for some of them) remove long-standing impediments to growth. Figure 13, second panel, presents adjustment needs based on country-specific r − g differentials, reflecting the initial debt levels. This implies a somewhat larger adjustment for higher debt countries, such as Japan and Italy.

  • Moreover, similar adjustments hide differences across countries in terms of the effort required to achieve them. In some countries, the initial CA primary deficit incorporates substantial temporary fiscal stimulus which is presumably easier to reverse than structural spending. In contrast, in countries with more limited stimulus, consolidation would need to address pre-existing structural weaknesses (see last two panels of Figure 13 for G-20 advanced economies).

Figure 13.
Figure 13.

Illustrative Fiscal Adjustment in Cyclically Adjusted Primary Balance, 2011–30

(In percent of GDP)

Notes: Crisis-related stimulus is provided only for G-20 economies. The baseline fiscal adjustment need for a uniform interest rate-growth differential across countries corresponds to the illustrative fiscal adjustment scenario depicted in Figure 11. The alternative scenario uses country-specific interest rate growth differentials. Until 2015, they use country-specific projections for the interest rates (computed as the implied interest rate from fiscal interest expenditures) and GDP growth rates. From 2016–30, country-specific differentials are determined as a function of the country’s post-crisis (2015) indebtedness relative to the advanced country average. Specifically, a country with a post-crisis debt ratio that is higher by 10 percentage points than the average is assumed to have a higher interest rate-growth differential by 0.25 percentage points, and vice versa for countries with lower-than-average post-crisis indebtedness (this assumption is conservative compared to empirical estimates on the link between indebtedness and interest and growth rates). For Australia, the figures do not reflect the latest federal government budget released May 11. For Greece (not shown), the illustrative required adjustment from 2011 to 2020 is 9.2 percent of GDP; this is premised on adjustment measures of 7.6 percent of GDP (as in the authorities’ program) being implemented in 2010. For Portugal and Spain, the figures do not reflect additional deficit reduction plans announced May 10.

27. Among emerging economies, illustrative adjustment needs vary equally widely.

China has fiscal space to continue supporting the economy, in particular by strengthening spending for education, health, and pensions. This would help reduce uncertainties about income security that have contributed to a sharp decline in the private consumption ratio in recent years (pre-dating the crisis) thus strengthening domestic demand and helping address global imbalances (Box 4). For several others also—for example, Chile, Kazakhstan, and Panama—little or no adjustment is needed, given relatively low initial debt levels and strong CA primary positions. Yet in others, the gap is large—up to 8 percentage points of GDP under the scenario assumptions—reflecting initial high debt, the impact of the crisis on CA primary balances, or both (Appendix 2). These economies need to adjust more rapidly.

28. The above scenario focuses on a gross debt target. Some countries, in particular those with large holdings of assets, prefer to focus their fiscal policy on the attainment of net debt targets. Accordingly, Appendix 2 presents, for advanced economies, the results of similar calculations based on achieving a net debt ratio of 45 percent of GDP, equal to the median for the advanced G-20 economies in 2007.23 Calculated adjustment needs are similar to those for gross debt with differences in the cumulative 10-year illustrative adjustment need exceeding 1 percent of GDP only for Canada (1.7 percent), Iceland (1.3 percent), and Ireland (1.2 percent). In each of these cases, the required adjustment needed to achieve the net debt target is less than that for the gross debt target.

Increasing Social Expenditures and Household Consumption in China

Household consumption as a share of GDP in China has fallen dramatically since 1980 and is low by regional and international standards (see figure below). In Asia, only India has experienced such a dramatic decline in its consumption-to- GDP ratio, though starting from a much higher level.

Most of the decline in China’s consumption ratio reflects a decline in the household consumption rate. A decline in consumption of GDP (the “consumption ratio”) can occur either because consumption is falling as a share of household income (a declining “consumption rate”), or because household income is falling as a share of GDP. Between 1990 and 2007, the fall in the consumption ratio is accounted for mostly by a decline in the household consumption rate and only in small part by the decline in the share of household disposable income in GDP.

ch03ufig01
Sources: CEIC Data, April 2010 WEO, and IMF staff estimates.

Studies have emphasized the role of decreasing government social expenditures in explaining the decrease in the consumption ratio in China. The withdrawal of the “iron rice bowl” over the last few decades has meant that Chinese households now have to save more to finance future expenditures on health, old age consumption, and education, so that risk-averse households respond by increasing “precautionary savings” substantially. A recent IMF study finds that increases in social expenditure in China could have sizable effects on household consumption: a 1 percent of GDP increase in spending allocated equally across education, health, and pension spending and financed by reducing fiscal surpluses of government and state enterprises would increase household consumption by 1.2 percent of GDP (Baldacci and others, 2010). Allocating a larger proportion of the expenditure increase to health and pensions would generate even bigger consumption impacts, because a larger proportion of these expenditures benefit the elderly who have higher propensities to consume. Allocating all of the 1 percent expenditure increase to health or pension would raise consumption by 1.3 percent and 1.6 percent of GDP, respectively. Targeting expenditures at poorer rural households would increase the impact further.

Although such expenditure increases could be financed out of existing surpluses in the short run, eventually they would have to be tax-financed to be fiscally sustainable. However, even then, the net impact on consumption would be positive. Financing fully through income taxation would reduce the consumption impact by half to 0.6 percent of GDP. The positive net impact reflects the redistributive nature of these tax-financed expenditure increases and a decrease in the need for precautionary savings.

29. The fiscal adjustment described above will be made more challenging by the spending pressures that will arise in the decades ahead, particularly in advanced economies. The adjustments discussed above do not take into account those needed to offset the spending pressures already in train due to population aging and other spending trend increases. In particular, for several countries, total adjustment required goes well beyond the net improvement needed in the primary balance, as measures will also be required to offset higher health and pension spending (let alone pressures arising from global warming). On average, spending increases in health and pensions are projected at 4 to 5 percentage points of GDP in advanced economies over the next 20 years (see IMF 2010c). The relative position across countries along these two dimensions—the needed change in the primary balance to lower public debt below 60 percent of GDP for advanced economies, and the increase in spending pressures for pensions and health—is illustrated in Figure 14. Countries with adjustment requirements clearly above the (simple) averages in both dimensions—those located far in the upper right quadrant—include the United States, Spain, the United Kingdom, France, and the Netherlands.

Figure 14.
Figure 14.

Illustrative Fiscal Adjustment and Projected Age-Related Spending Increases in 2011–2030

(In percent of GDP)

Source: IMF staff estimates and projections; IMF (2010c).Note: Fiscal adjustment refers to improvement in the cyclically adjusted primary balance needed to achieve the illustrative gross government debt target. Circles indicate debt ratios above 60 percent for advanced economies and 40 percent for emerging economies, projected at end-2012 (higher debt); triangles indicate debt ratios below 60 percent for advanced economies and 40 percent for emerging economies, projected for the same period (lower debt). See note in Figure 11 for further details. The vertical and horizontal lines represent unweighted averages. For Australia, the figures do not take into account the federal government budget, released on May 11, which envisages a return to federal government surpluses by 2012/13. For Greece (not shown), the illustrative 2011–30 adjustment need is 9.2 percent of GDP, after measures of 7.6 percent of GDP undertaken in 2010. The increase in health and pension spending is projected at 7.6 percent of GDP.

30. In some countries, fiscal adjustment at the central government level will have to be accompanied by adjustment at the subnational level. The crisis has adversely affected the finances of local governments in many countries. Revenues collapsed, and in many cases, spending needs increased. Country responses have differed: some have allowed local deficits to widen, while others opted not to ease limits on local government deficits and borrowing, responding to the crisis with procyclical spending cuts, tax base broadening, and even tax rate increases (Appendix 4). Countries that allowed a discretionary countercyclical easing at the subnational level—for example, cutting tax rates or increasing investment spending—will need to gradually reverse this policy to ensure that local governments contribute to fiscal adjustment and debt reduction. Where local governments have cut spending and raised revenues, recovery should ease pressures on local budgets by strengthening revenue collection, allowing a phase-out of at least some of the spending restraint or tax measures.

B. Medium-term Adjustment Plans

31. Most advanced economies plan significant adjustment starting from 2011, but few details about concrete policy measures have been spelled out. Announced consolidation targets and timeframes reflect the different dimensions of country adjustment needs. Advanced G-20 economies with the lowest deficits projected for 2010 (Australia, Canada, Korea) envisage returning close to budget balance or surplus by 2012/13–16. For EU member states, requirements under the Stability and Growth Pact dictate an adjustment that would bring budget balances below the 3 percent of GDP deficit threshold between 2012 and 2014. By contrast, despite sizable adjustment in medium-term budget proposals in the United States, an overall deficit of about 6 percent of GDP would remain by 2014 (Table 8).

32. Among emerging economies, some have announced adjustment targets, albeit predominantly for the short term. For instance, Brazil plans to restore the deficit of the non-financial public sector to its precrisis level of 1.5 percent of GDP. Mexico aims to return the debt ratio to a declining trend by 2011 and to balance the budget by 2012.

33. The planned composition of adjustment during 2010–15 differs between advanced and emerging economies. From broad announcements made so far, it appears that advanced economies intend to rely more on expenditure adjustment or a combination of spending and revenue measures, while emerging economies foresee greater reliance on revenue recoveries (Table 9). Based on IMF WEO projections, real primary spending is expected to decline modestly in the advanced economies over 2010–12 and subsequently to grow, albeit at a much slower pace compared to the 2007–09 period (Figure 15). In emerging economies, revenue growth, which slowed markedly during the crisis, is expected to recover; primary spending will continue to rise in line with robust GDP growth.

Table 8.

Medium-term Fiscal Consolidation Plans

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Sources: IMF country reports and authorities’ reports; IMF staff estimates and projections.
Table 9.

G-20 Economies: Composition of Adjustment Plans

article image
Sources: Authorities and IMF country reports; and IMF staff projections.

Fiscal adjustment needs are calculated as changes needed in the CAPB to achieve certain debt targets (see Appendix 2 for details on the methodology and variations in debt targets for advanced and emerging economies).

Figure 15.
Figure 15.

Projected Real Revenue and Spending Levels, 2007–15

(Index, 2007=100)

Source: IMF staff projections; April 2010 WEO.

34. Plans for reforms in entitlement spending vary. Some countries have already undertaken meaningful pension reforms (e.g., Italy, Sweden), or have relatively limited entitlement coverage (China). In several countries health care reforms have recently moved onto the policy agenda (e. g., France, Germany), although few concrete plans have been announced (Table 10). The health care reform just passed in the United States aims primarily at expanding coverage, although the Congressional Budget Office (CBO) projects that higher outlays for expanded coverage will be more than offset by reduced payments to healthcare providers and higher payroll tax contributions (Box 5).

35. Action on entitlement reform should start now in all countries facing aging pressures, but the timing of stimulus withdrawal should vary according to country circumstances. Pension and health reforms may take several years to bear fruit, indicating that there is little reason to delay their implementation. Some potential reforms, such as an increase in retirement ages, may even have a positive effect on demand in the short term, as individuals reduce their saving in the expectation of funding a shorter retirement period. For most countries, the timing of the withdrawal of stimulus will depend on macroeconomic conditions. As noted, many emerging economies facing a rapid pickup in growth have already begun withdrawing fiscal stimulus this year. Should the baseline scenario of the April WEO materialize, all countries should be in a position to withdraw stimulus spending by 2011, when the recovery in advanced economies is expected to be widely consolidated. Of course, countries facing market pressures have already begun withdrawing stimulus spending, and will need to continue doing so even if—as is likely to be the case—macroeconomic conditions remain challenging.

Table 10.

G-20 Economies: Planned Health Care and Pension Reforms as Part of the Exit Strategy 1/

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Sources: IMF (2010c); IMF staff estimates; IMF country reports; and authorities’ reports.

Includes only reforms recently adopted or announced. Earlier reforms, which are in part being gradually implemented, such as increases in the retirement age, are reflected in projections of age-related spending increases and not listed in the table.

See IMF (2010c) for the methodology of the projections.

Health Care Reforms in the United States 1/

In March 2010, the U.S. Congress passed health care reform legislation that aims mainly to expand insurance coverage. Coverage is expected to increase by 11 percentage points to reach 94 percent of the population by 2019. This expansion will be achieved by: (i) raising limits on Medicaid eligibility to 133 percent of the poverty line; and (ii) providing tax breaks and subsidies to individuals between 133 percent and 400 percent of the poverty line who purchase insurance on exchanges. The law also forbids insurance companies from denying coverage for preexisting conditions.

The legislation includes measures for cost containment and revenue increases, which the CBO projects will result in small budgetary savings. These measures include: (i) reductions in the growth of Medicare payments to providers; (ii) increases in payroll taxes for Medicare hospital insurance; and (iii) an excise tax on expensive employer-provided health plans. The CBO estimates that the bill would reduce the federal budget deficit by a cumulative US$143 billion by 2019, or about 1 percent of today’s GDP (or about 0.1 percent of GDP per year, on average), with further savings of about ½ percent of GDP in the following decade (see figure below). There are some risks to the CBO estimates, however, including that the substantial decrease in Medicare payment rates to health care providers may prove difficult to implement.

ch03ufig02

Estimated Effects of U.S. Health Care Reform

(In percent of GDP)

Source: United States Congressional Budget Office.
1/

Prepared with Marcello Estevao and Evridiki Tsounta of the IMF Western Hemisphere Department.

15

For Japan, a target of 200 percent of GDP was used for gross debt (equivalent to a target of 80 percent for net debt). Even with this less ambitious target—which is close to the precrisis level—the adjustment in the primary balance for Japan is the largest in the advanced economy grouping, as discussed below.

16

This assumes: (i) that the CA primary surplus target would be achieved by 2020 and maintained for the following decade; (ii) an average interest rate-growth differential of 1 percentage point; and (iii) that the whole adjustment is implemented through the improvement in the primary balance. Of course, countries with large asset positions that exceed their (country-specific) needs could choose to reduce their gross debt by liquidating assets (although this would have no impact on net debt ratios). Even in these cases, however, an adjustment that at least eliminates any initial primary deficit will be needed.

17

These adjustments are averages using PPP GDP weights. The simple cross-country average is much smaller because some of the countries with the largest adjustment needs are themselves large.

18

See Baldacci and Kumar (2010) for a more detailed discussion of these results. Similar results are found in previous studies: see, for instance, Faini (2006) and Laubach (2009).

19

Strictly speaking, the difference would be between stabilizing debt at 2015 levels (110 percent of GDP) and bringing debt down to the 2007 levels (73 percent of GDP). This is similar to the scenario described above, as in the latter the debt ratio is lowered to an average of 74 percent (60 percent for all countries except approximately 200 percent of GDP for Japan).

20

Preliminary evidence suggests that an increase in U.S. bond yields by 100 basis points is associated with an increase in emerging market bond yields of around 30 to 60 basis points (taking into account domestic conditions and global liquidity).

21

The analysis pays particular attention to a range of estimation issues including reverse causality, endogeneity, and outliers.

22

This is consistent with the econometric results relating interest rates and potential growth to the debt level described above.

23

The target is 80 percent for Japan.

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    Advanced and Emerging Economies: Illustrative Scenario for Fiscal Adjustment

    (In percent of GDP)

  • View in gallery

    Advanced Economies: Illustrative Fiscal Adjustment Need as Function of Debt Target and Interest Rate-Growth Differential

  • View in gallery

    Illustrative Fiscal Adjustment in Cyclically Adjusted Primary Balance, 2011–30

    (In percent of GDP)

  • View in gallery
  • View in gallery

    Illustrative Fiscal Adjustment and Projected Age-Related Spending Increases in 2011–2030

    (In percent of GDP)

  • View in gallery

    Projected Real Revenue and Spending Levels, 2007–15

    (Index, 2007=100)

  • View in gallery

    Estimated Effects of U.S. Health Care Reform

    (In percent of GDP)

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