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World Development Report 1985 International capital flows and economic development: Principal themes of the Bank’s 1985 Report

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International Monetary Fund. External Relations Dept.
Published Date:
September 1985
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Francis X. Colaço

The economic turbulence of the past few years has subsided. The recovery of industrial economies in 1983–84, policy adjustments by many developing countries, and flexibility by commercial banks in dealing with debt-servicing difficulties have all helped to calm the atmosphere of crisis. Economic growth has also recently resumed in many developing countries. This does not mean, however, that the world economy has regained its momentum of the 1960s or that development is again proceeding rapidly. Growth has slowed in most developing countries that experienced debt-servicing difficulties and even in many of those that did not. Average per capita incomes are no higher in real terms in most of Africa than they were in 1970, and in much of Latin America than they were in the mid-1970s. Dozens of countries have lost a decade or more of development.

The World Development Report 1985 was prepared by a team led by Francis X. Colaço and comprising Alexander Fleming, James Hanson, Chandra Hardy, Keith Jay, John Johnson, Andrew Steer, Sweder van Wijnbergen, and K. Tanju Yürükoglu. The Economic Analysis and Projections Department, under the direction of Jean Baneth, supplied data for the Report. Enzo Grilli and Peter Miovic coordinated the work on projections. The work was carried out under the general direction of Anne 0. Krueger and Costas Michalopoulos.

The World Development Report 1985 is published in English, Arabic, Chinese, French, German, Japanese, Portuguese, and Spanish. See page 18 for ordering details.

The experience of the past few years has raised many questions about the role of international capital in economic development—the theme of the World Bank’s World Development Report 1985. It is important not to lose sight of the fundamentals of international capital. Capital has traditionally flowed from richer countries to those at earlier stages of development, where the expected rates of return tend to be higher. Questions about the nature of capital flows, their terms, and their uses were relevant in the 19th century and remain so today.

The 1985 Report offers a broad and long-term perspective on the role of international capital in economic development. It emphasizes that international flows of capital can promote global economic efficiency and can allow countries with balance of payments deficits to strike the right balance between reducing their deficits and financing them. However, the availability of international capital also involves risks: first, it may allow countries to delay the policy reforms required for adjustment; and second, countries may borrow too much, if they misjudge the way external economic conditions are going to evolve.

There is considerable evidence that capital flows, often accompanied by technical know-how, have played a part in the progress made by developing countries over the past 20 years. Foreign capital has also helped individual countries to cushion shocks—either internal ones, such as harvest failures, or external ones, such as large fluctuations in commodity prices or recessions in industrial economies. Countries that accompanied borrowing in the difficult 1970s with policy reforms restored rapid growth and avoided debt-servicing difficulties. Others used borrowing to avoid adjustment and many of these ran into debt-servicing problems requiring even more drastic and costly adjustment later.

The historical context

The 1970s and early 1980s saw a substantial increase in capital flows to developing countries, and, compared with the 1960s, a decrease in the relative importance of concessional and nonconcessional official flows. As a result, both the gross and net debt of developing countries increased sharply. Between 1970 and 1984 the outstanding medium- and long-term debt of developing countries expanded almost tenfold, to $686 billion, despite a decline in capital flows since 1981 (see chart). The most striking feature of this growth was the surge in lending by commercial banks, whose share of total new flows to developing countries increased from 15 percent in 1970 to 36 percent in 1983.

The debt-servicing indicators of developing countries deteriorated, as their debt increased and real interest rates rose and export growth rates slowed, particularly after 1979. The ratio of debt to GNP more than doubled from 14 percent in 1970 to almost 34 percent in 1984. The ratio of debt service to exports rose from 14.7 percent in 1970 to a peak of 20.5 percent in 1982, declining to 19.7 percent in 1984. Interest payments on debt increased from 0.5 percent of GNP in 1970 to 2.8 percent of GNP in 1984 and accounted for more than half of all debt-service payments in that year. These averages conceal wide regional and country differences.

Dramatic though the recent growth of foreign borrowing has been, it is not unprecedented. The volume of external capital flows has often been larger as a proportion of GDP of investing countries or of domestic investment in recipient countries during earlier periods than it was in the 1970s. Debt-servicing difficulties were quite common in the late 19th and early 20th centuries and usually were caused by a combination of poor domestic policies and a deteriorating world environment. Debt repudiations and defaults, however, were not confined to developing countries; some borrowers in the United States, for example, defaulted on their external debts in the 50 years prior to World War I.

By historical standards, debt-servicing difficulties in the 1960s and 1970s do not seem unduly serious. In the 1970s, for example, despite the sharp fall in their terms of trade in 1973–74, an average of three developing countries a year rescheduled their debts. It is only in the 1980s that debt problems have multiplied. The number of reschedulings rose to 13 in 1981 and to 31 (involving 21 countries) in 1983 and a similar number in 1984.

In recent years, developing countries have become more vulnerable to debt-servicing difficulties for three related reasons. First, the volume of loans has increased to a level much above that of equity finance, resulting in an imbalance between debt and equity. Second, the proportion of debt at floating interest rates has risen dramatically, so borrowers are hit directly when interest rates rise. Third, maturities have shortened considerably, in large part because of the declining share of official flows.

Another major and disturbing difference today is that many of the countries with debt-servicing difficulties are in the low-income group. Their aid receipts have been erratic mainly because of variations in bilateral ODA. To make up for the lack of adequate ODA flows and direct investment many low-income and lower middle-income countries borrowed on commercial terms and accumulated large amounts of debt in the period after 1970. Low-income countries that, on the contrary, were conservative in their recourse to commercial capital successfully avoided debt-servicing difficulties.

The historical perspective reveals certain broad characteristics about debt-servicing problems. The financial links between industrial and developing countries depend on three related variables: (1) the policies of industrial countries; (2) the policies of developing countries; and (3) the financial mechanisms through which capital flows to developing countries. No analysis of international finance is complete unless it takes account of all these variables.

Industrial country policies

The fiscal, monetary, and trade policies of industrial countries largely determine the external climate for developing countries. The connection is not simply through growth and protectionism. Increasingly the links are financial through changes in the availability of finance and movements in interest rates and exchange rates. This became clear in 1979–80, for example, when US monetary policy switched from targeting interest rates to targeting monetary aggregates. Interest rates became more volatile. These policies, along with increasing fiscal deficits in industrial countries, contributed to high real interest rates. The result was abrupt increases in debt-service payments. Latin America, with a higher proportion of floating rate debt, was more affected by this change than either East Asia or Africa. Developing countries find it difficult to adjust to sudden and large increases in debt-service payments. In the early 1980s the recession in the industrial countries reduced export volumes and weakened commodity prices for developing countries at a time when real interest rates were rising, making it hard for many countries to service their debts.

Net flows to developing countries, 1970–83

Billions of 1980 dollars

Source: World Bank, World Development Report 1985.

The recovery since then in the industrial countries has helped to ease some of the liquidity pressures on developing countries. Real interest rates have softened a little but remain at historically high levels. World trade expanded rapidly. However, the world recovery in 1983–84 did not lead to the normal cyclical rise in commodity prices in dollar terms. This was in part due to the US dollar’s further appreciation, as well as to technological and other factors affecting the demand for commodities. Thus net primary commodity exporters (such as Brazil) benefited less than countries that are net commodity importers (such as Korea). In addition, all developing countries continue to be affected by protectionist measures in the industrial economies.

For the future, the effects that industrial countries have on developing countries will depend primarily on what happens in two areas of policy: real interest rates and protectionism. Large budget deficits in industrial countries remain an obstacle to lower interest rates. Credible measures are needed in those countries to reduce public sector reliance on domestic and foreign savings; this could lower interest rates and foster growth. The United States has recently announced steps that, when implemented, would permit significant reduction in its fiscal deficits in the next few years. Avoiding the recessionary impact of such a policy change will require careful coordination of monetary and fiscal policies among the major industrial countries.

The second issue of vital concern to developing countries is protectionism. To service their foreign debts, the largest debtors will need to run sizable trade surpluses in the next few years. Yet many import restrictions—on steel, sugar, and beef, for example—have affected primarily major debtors including Argentina, Brazil, Korea, and Mexico. Other protectionist measures, such as the Multifibre Arrangement, affect a broader range of countries.

When developing countries cannot earn the foreign exchange to expand their imports, exporters in the industrial countries suffer. For example, US exports of manufactures to major debtors fell by 40 percent between 1980–81 and 1983–84. Such harm is widespread, since industrial economies run a surplus on trade in manufactured goods with developing countries. Protectionism, by curtailing import growth of developing economies, slows the adjustment and growth that the industrial countries themselves so badly need.

Over the long term, protectionist barriers in the industrial world can have a profound effect on development strategy. They suggest to governments in developing countries that a strategy based on export growth is highly risky, and may thus encourage a return to the inward-looking policies of earlier years. There is abundant evidence that inward-looking policies are bad for growth and employment in the developing countries and also reduce the scope for industrial countries to promote improvements in productivity in their own economies.

Developing country policies

The past dozen years have underlined the crucial role of domestic policies in determining the performance of developing countries, particularly in the use of foreign finance to promote growth through higher investment and technology transfers. In the 1970s it was right for countries to borrow when real interest rates were low or negative—but only if they followed appropriate policies in three principal areas—key economic prices, exchange rate and trade policies, and domestic savings—and invested in economically justified projects. It was wrong to assume that low interest rates would continue, and that it is always expensive to reverse investment decisions. Such mistakes were quickly exposed when world conditions deteriorated in the early 1980s.

Developing countries suffered in 1979–84 from a combination of more expensive oil, historically high real interest rates, prolonged recession in industrial economies, and more trade barriers. Despite this, as many as 100 countries continued to service their foreign debt without interruption. Some experienced only small external shocks, including countries that were oil exporters or those that benefited from workers’ remittances (for example, certain Asian and Middle Eastern countries); many of these countries are now having to deal with the effects of lower oil prices and reduced workers’ remittances. Some had borrowed only a little or mainly on concessional terms in the 1970s (for example, China, Colombia, and India). Other borrowers undertook economic policy reforms that facilitated debt servicing (for example, Indonesia and Korea).

Countries that ran into debt-servicing difficulties, however, were not necessarily those that had suffered the biggest shocks. They were countries that had borrowed and failed to adjust or had not tackled the new problems with sufficient urgency. Among these were the low-income countries of Africa, whose development is a long-term process constrained by weak institutional structures, a shortage of skills, and often (as in the past ten years) natural disasters as well. These countries had traditionally used concessional capital; in the 1970s many of them borrowed on commercial terms both for consumption and for investment in large public projects, many of which contributed little to economic growth and to debt servicing.

Another group of countries with debt difficulties includes many countries in Latin America and some major debtors. The reasons for their financing problems are more complex, but three common features are: (1) fiscal and monetary policies that were too expansionary to achieve a sustainable external balance; (2) overvalued exchange rates that prevented exports from competing on world markets and encouraged capital flight; and (3) investment increases that were even larger than the increases in domestic savings. (See “Domestic and external causes of the Latin American debt crisis” by Eduardo Wiesner, Finance & Development, March 1985.)

The diverse experiences of developing countries emphasize certain basic lessons for policy. One lesson can be summarized as the need for flexibility in the face of uncertainty and changes in the external environment. Countries as varied as India, Indonesia, Korea, and Turkey have adapted their economic policies to changed circumstances. The most critical changes in the short term are the ability to reduce fiscal deficits and adjust real exchange and interest rates. When, for political or other reasons, countries cannot adjust their policies quickly, they should be conservative in resorting to foreign borrowing.

A second lesson is that the policies required to make the best use of external finance are essentially the same as those that make the best use of domestic resources. A country must earn a return on its investments that is higher than the cost of resources used. However, in the case of foreign finance, a country also has to generate enough foreign exchange to cover interest payments, plus remittances of dividends and profits. This depends on actions in three areas:

• Key economic prices must be aligned with opportunity costs. This encourages activities in which the country has a comparative advantage and increases the flexibility of productive structures. Subsidies, when used, should be carefully targeted, for example to the poorest segments of society. Further, investment decisions are influenced by the appropriateness of pricing structures, including interest rates. Governments need to evaluate carefully their own investment programs and to create a framework of incentives to ensure that private investors allocate resources in the most efficient way.

• Exchange rates and trade policies also play a major role. In the 1970s and early 1980s many countries allowed their exchange rates to become overvalued and implemented inappropriate trade policies. This biased production toward the domestic market, stimulated imports, and provoked capital flight. Protectionist trade policies adversely affect the efficiency of utilization of resources and expansion of trade.

• Efforts to raise domestic savings should be strengthened in both the public and the private sectors, despite the availability of external capital. The correct role of foreign finance is to supplement domestic savings; it must not substitute for them. The danger of poor savings performance was well understood by many governments as evidenced by the fact that, in the 1970s, two thirds of a sample of 44 developing countries increased their domestic savings in relation to GNP.

Managing foreign flows

Policies determining the level of domestic savings and investment also determine the need for foreign borrowing, so the management of capital flows should be an integral part of macroeconomic management. Certain aspects of debt management deserve special attention.

The first issue is whether and how governments should regulate foreign borrowing and lending by the private and public enterprise sectors. The answer depends fundamentally on a government’s macroeconomic and incentive policies; in general, less government intervention is needed when prices, interest rates, and exchange rates reflect opportunity costs. Although some governments have constructed elaborate controls over capital inflows and outflows, experience strongly suggests that these are no substitute for sound macroeconomic policies. Nonetheless, some procedures for regulating capital movements—prior approval for borrowing, minimum maturity or deposit requirements, or withholding taxes—have sometimes usefully complemented fiscal, monetary, and trade policies.

The second broad area of concern is the composition of capital flows and debt. This involves decisions about: (1) the terms of foreign borrowing—interest, maturity, and cash flow profiles; (2) the currencies in which liabilities are denominated; (3) the balance between fixed rate and floating rate instruments; (4) ways of sharing risk between lenders and borrowers (including the balance between debt and equity); and (5) the level and composition of a country’s reserves. It is not possible to formulate precise rules for external debt management that will apply to all countries. The experience of the past few years, however, argues for prudence by developing countries in deciding on both the volume of foreign borrowing and its composition, and in maintaining enough reserves to give a country time to adjust to domestic or international pressures without unduly jeopardizing economic growth.

Many countries fail to manage capital flows effectively because of inadequate data, a lack of technical expertise about financing options, and an absence of institutional arrangements to integrate debt management with macro-economic decision making. In all these areas, institutional development is an important priority.

Table 1Current account balance and its financing in developing countries, 1984 and 1990(In billions of 1980 dollars)
19841High

1990
Low

1990
Net exports of goods and nonfactor services14.5–38.66.3
Interest on medium- and long-term debt–59.3–44.9–76.3
Official–10.8–12.8–18.4
Private–48.5–32.1–57.9
Current account balance2–36.4–60.7–48.6
Net official transfers12.215.214.5
Medium- and long-term loans351.355.136.6
Official26.220.420.2
Private25.134.716.4
Debt outstanding and disbursed702.5716.2741.4
As percentage of GNP33.824.727.8
As percentage of exports135.498.2133.1
Debt service as percentage of exports19.716.028.0
Source: World Bank data.Note: The table is based on a sample of 90 developing countries. The GNP deflator for industrial countries was used to deflate all items. Details may not add to totals because of rounding. Net exports plus interest does not equal the current account balance because of the omission of net workers’ remittances, private transfers, and investment income. The current account balance not financed by official transfers and loans is covered by direct foreign investment, other capital (including short-term credit and errors and omissions), and changes in reserves. Ratios are calculated using current price data.

Estimated.

Excludes official transfers.

Net disbursements.

Source: World Bank data.Note: The table is based on a sample of 90 developing countries. The GNP deflator for industrial countries was used to deflate all items. Details may not add to totals because of rounding. Net exports plus interest does not equal the current account balance because of the omission of net workers’ remittances, private transfers, and investment income. The current account balance not financed by official transfers and loans is covered by direct foreign investment, other capital (including short-term credit and errors and omissions), and changes in reserves. Ratios are calculated using current price data.

Estimated.

Excludes official transfers.

Net disbursements.

Financial mechanisms

Developing countries account for only a small proportion of international flows of capital, so their influence on the international financial system is limited. The system itself evolves in response to three main factors. First is the external environment. For example, changes in regulations, financial innovations, and high and volatile inflation in the 1970s led investors to lend at floating rather than fixed rates. Second, the demand for the services of financial markets and institutions is affected importantly by global payments imbalances. For example, OPEC countries in the 1970s and early 1980s initially preferred to keep their surpluses in highly liquid form, so commercial bank deposits and lending increased. More recently, the large current account deficits run by the United States, which have their counterpart in surpluses in Japan and other industrial countries, have led to a much larger role for international asset markets. Third is the preferences of financial institutions. For example, in the 1970s commercial banks chose to lend abroad to satisfy their own portfolio and profitability objectives.

In the short term, developing countries have to make the most of the opportunities presented by the international financial system. For the long term, the key policy questions are: How can the stability of external capital flows be enhanced and lending by banks be restored? And what arrangements can be made for the future financing of external deficits, including enough concessional assistance, to meet the needs of low income countries?

Table 2Net financing flows to developing countries, and projections(In billions of 1980 dollars)
Growth rate1

(Percent)
19901985–90
Type of flow1984HighLow1970–80HighLow
Official development21.825.124.26.12.72.0
assistance2
Nonconcessional loans41.845.226.912.34.4–5.9
Official16.610.510.513.92.32.3
Private25.134.716.411.95.1–9.5
Direct investment9.612.311.85.84.23.2
Total373.282.662.99.13.8−1.7
Source: World Bank data.

Average annual percentage change.

Includes ODA grants (official transfers). DAC reporting includes, and the World Bank Debtor Reporting System excludes, ODA flows from nonmarket economies and the technical assistance component of grants. There are also differences in coverage of recipient countries in the two data sources.

Excludes short-term capital and reserve changes.

Source: World Bank data.

Average annual percentage change.

Includes ODA grants (official transfers). DAC reporting includes, and the World Bank Debtor Reporting System excludes, ODA flows from nonmarket economies and the technical assistance component of grants. There are also differences in coverage of recipient countries in the two data sources.

Excludes short-term capital and reserve changes.

The answers lie in five areas:

• Longer maturities. Developing countries can borrow for the long term, though seldom directly from the market; they will continue to rely almost exclusively on the intermediation of the World Bank and regional development banks for the next few years. Financial innovation to expand the range of maturities available to developing countries would help them to manage their debt and reduce refinancing risks.

• Hedging. The financing instruments used in the 1970s meant that developing countries assumed the risks of adverse developments in the world economy. There was no effective risk sharing. Instruments for hedging risks exist in many financial markets and should be used to a greater extent in lending to developing countries.

• Commercial risk sharing. Conventional bank loans do not involve sharing commercial risks; foreign direct and portfolio investment does. The introduction of equity-based instruments in lending to developing countries is another area where progress could be made since they involve sharing of commercial risk.

• Secondary markets. As most commercial lending to developing countries in the 1970s was by banks, it tended to increase risks by concentrating assets in a single group of creditors. The phased expansion of secondary markets for some types of developing countries’ liabilities could widen the range of lenders, diversify the risks, and enhance the stability of lending.

• Aid volume and effectiveness. Low-income countries need considerably more development aid than is available at present. They also need to use aid efficiently. Donors can improve their own efficiency by focusing their aid primarily on development objectives and by coordinating their efforts within programs agreed with the recipient.

Prospects and options

How much and what kind of foreign finance will developing countries need in the years ahead? That question can be answered only by analyzing the global outlook for growth, trade, interest rates, and so on. Traditionally, the Bank’s annual World Development Report presents alternative scenarios for ten years ahead. These, it needs emphasizing, are not predictions; their outcome depends on the policies adopted in industrial and developing countries. Nor do they allow for exogenous shocks to the world economy. Last year’s Report contained scenarios to 1995. The discussion in this year’s Report is in the context of last year’s scenarios, but pays greater attention to the next five years.

The next five years will be a period of transition. During that time, about two thirds of the debt of the developing countries will need to be repaid or rolled over. The constructive and collaborative actions, including multiyear debt restructurings, taken by debtors, creditors, and international agencies in recent years need to be continued. Their objective is to accelerate the return to creditworthiness of countries that are pursuing sound economic policies, but have sizable short- to medium-term debt-servicing requirements. These actions need in particular to be extended to countries—several middle-income exporters of primary commodities and many low-income African countries—where debt-servicing difficulties and development problems are intertwined. Consideration needs to be given to the extent to which multiyear debt restructuring for official credits and other arrangements might be feasible on a case-by-case basis, as part of overall financing packages supporting stabilization and adjustment, particularly in low-income sub-Saharan African countries committed to strong adjustment efforts.

Over the past few years, many developing countries have made progress in dealing with their financial difficulties. The economic situation, however, remains fragile in many countries. GDP growth in 1980–85 is currently estimated at slightly more than one half that of 1973–80. Exports in 1980–85 have grown at close to 6 percent a year, but the pressure of continued high interest payments has kept import growth at only a little more than 1 percent a year. Substantial trade surpluses run by many developing countries have been used to meet greatly increased interest payments. The high level of real interest rates is thus one of the critical variables whose course will influence outcomes in the next five years. Developing countries need to keep the rate of growth of export earnings above the rate of interest, even if the current account (net of interest payments) remains in balance, if the major debt ratios are to return to more sustainable levels. This will depend not only on their own policies but also on the rate of growth of industrial economies and whether or not protectionist measures are rolled back.

Two simulations—a Low and a High—have been prepared by Bank staff for the period 1985–90. Both assume that developing countries continue with their present course of policies, which in many cases (as, for example, in some low-income Asian economies) imply substantial policy reforms and adjustment efforts. Policy improvements in three principal areas—key economic prices, exchange rates and trade policies, and domestic savings. These contribute to efficiency in the use of resources and to export competitiveness. As for industrial economies, the difference between the simulations is that the Low case assumes a set of policies that fail to address current problems and as a result lead to further problems, while the High one embodies policy changes that result in greater progress in adjustment.

The Low simulation assumes: no progress in reducing budgetary deficits and in improving the monetary-fiscal balance so that real interest rates remain high; a failure to tackle labor market rigidities so that unemployment stays high and real labor costs continue to increase; and a substantial increase in protection. The High simulation, by contrast, assumes progress on all these fronts—lower interest rates, lower unemployment, and a reduction in protection.

For developing countries, in the High simulation output grows at a healthy 5.5 percent a year (or 3.7 percent a year per capita), and there is a major improvement in all the major debt indicators. The Low simulation produces a more problematic outcome: growth slows to 4.1 percent a year (or 2.3 percent a year per capita). But, if there is a sizable reduction in economic growth, the impact on debt servicing is even more striking. A combination of high real interest rates and protection makes debt servicing considerably more difficult. The main debt indicators deteriorate; for a large number of countries debt-service ratios reach high levels. The volume of concessional aid declines as a result of slower growth in industrial economies, and “involuntary” lending, in the face of deteriorating creditworthiness, continues to be required.

The two simulations outline a continuing bleak outlook for many low-income African countries. In the High simulation, their average per capita income stagnates at present reduced levels; in the low simulation, there is yet another period of falling per capita incomes. Special efforts are therefore needed to deal with those prospects. These must be based on major changes in African programs and policies and supported with additional external assistance, over and above that projected in the High simulation.

The challenge for the next five years is to ensure that the world reaches the High case. It is quite clear that foreign capital will play a significant part in meeting the challenge of faster growth. Actions by creditors, debtors, and the international community would contribute under these circumstances to international capital resuming its productive role in economic development.

Role of the Bank

In contributing to the resumption of growth and the restoration of creditworthiness of the developing countries, the World Bank is addressing investment and institutional development issues crucial to sustaining longer-term progress. Against the background of growing strength in domestic institutions in borrowing countries and much greater resource scarcity than in the 1960s and 1970s, Bank assistance is helping governments to strike an appropriate balance between additional investments and the maintenance of existing capacities, to achieve greater selectivity and efficiency in public sector investments, and to develop a framework of policy and institutional arrangements conducive to the growth of activities in the private sector.

The financial resources provided directly by the Bank make important contributions to restored growth and momentum to development, but they can never be more than a rather small proportion of the total resources required. The Bank is, therefore, strengthening its catalytic functions, particularly with respect to aid coordination in sub-Saharan Africa, cofinancing with commercial banks and export credit agencies, and the promotion of private investment. In addition to its direct lending, the tasks of complementing and—to the extent possible—exercising a constructive influence on capital flows from other sources are also important factors in shaping the future role of the Bank.

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