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Fiscal deficit and its impact on inflation, Causality and Co-integration: The
Experience of Pakistan (1960-2010)
Ammama (Corresponding Author)
Department of Economics, Preston University Islamabad, Pakistan
E-mail: [email protected]
Dr. Khalid Mughal
Assistant Professor, Preston University Islamabad, Pakistan
E-mail: [email protected]
Dr. Muhammad Aslam Khan
Professor, Preston University Islamabad, Pakistan
E-mail: [email protected]
ABSTRACT
The main objective of this paper is to examine the impact of fiscal deficit on inflation. The fiscal
deficit in Pakistan continues to deteriorate and pose risks for sustainability of growth in the
longer time horizon. This paper reexamines the issue in the light of broader data and such
modeling approach which incorporates the key features of the theory. The paper establishes that
within sample, inflation in Pakistan is mainly attributed to unsustainable fiscal deficit. The
question whether fiscal deficit generates inflation in long term prespective or otherwise,
Cointegration and Granger-causality test are employed. Secondary data from 1960 to 2010 show
a strong relationship between fiscal deficit and inflation. Growth in deficits, whether measured
by amounts or by deficit-output ratios, positively Granger causes inflation. So this study
concluded that fiscal deficit displayed a powerful effect on inflation in Pakistan and there is need
of coordination between monetary and fiscal policy to curb the inflation. From Engel-Granger
cointegration test there exist a long run relationship between BD [budget deficit] and CPI
[consumer price index].
Key Words: Fiscal deficit, inflation, GDP (gross domestic product) growth, BDGDP (budget
deficit ratio to GDP growth), Pakistan
Paper Type: Research Paper
INTRODUCTION
The fiscal deficit is the difference between the government's total expenditure and its total
receipts (excluding borrowing). The elements of the fiscal deficit include (a) the revenue deficit,
which is the difference between the government’s current (or revenue) expenditure and total
current receipts (that is, excluding borrowing) and (b) capital expenditure. The fiscal deficit can
be financed by borrowing from the Central bank of Pakistan. (Which is also called deficit
financing or money creation) and market borrowing (from the money market, that is mainly from
banks). Two arguments are generally given in order to link a high fiscal deficit to inflation. The
first argument is based on the fact that the part of the fiscal deficit which is financed by
borrowing from the central bank of Pakistan leads to an increase in the money stock. Some
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people believe that higher money stock automatically leads to inflation. The second argument
linking fiscal deficits and inflation is that in an economy in which the output of some essential
commodities cannot be increased, the increase in demand caused by a larger fiscal deficit will
raise prices. (Bhattacharya, 2009).
Fiscal based theories of inflation have been especially prominent in the developing countries
literature, where it has long been recognized that less efficient tax collection, political instability,
and more limited excess to external borrowing tend to lower the relative cost of seignorage in
these countries. (Alesina and Drazen, 1991; Cukierman, Edwards, & Tabellini, 1992; Calvo and
vegh.1999). Several institutional and structural factors are believed to cause the expenditure-
adjustment coefficient to exceed the revenue-adjustment coefficient. Even if governments fully
recognize the need to restrain expenditures during periods of inflation, they find it difficult to
reduce their commitments in real terms. (Aghevli & Khan, 1978).
Catao and Terrones (2005), using panel of 23 emerging market countries for the period 1970-
2000 to investigate determinants of inflation. They found that a one percentage point
reduction in the ratio of fiscal deficit to GDP lowered long-run inflation by 1.5 to 6 percentage
points. Researchers had checked the impact of fiscal deficit on inflation and how fiscal deficit
always leads towards inflation in Pakistan. And how large budget deficits lower the GDP growth
and budget deficit ratio to GDP growth. Researchers had checked that fiscal deficit is efficient
determinant of inflation. And verify the gap of GDP growth and budget deficit ratio to GDP
growth in Pakistan. Methods of Unit Root Test, Granger Causality Test and co-integration are
used to verify the empirical results.
The objective of this study is to find out the direct or indirect impact of fiscal deficit on inflation
and finds out how non-planned expenditures cause huge fiscal deficit inflation in Pakistan. To
throw light upon these perspectives, the relationship between budget deficit and inflation is to be
examined. Secondly it investigates for long run relationship between these variables with current
data.
LITERATURE REVIEW
An economy going through a recession the government is not allowed to play any role in
boosting demand. Domestic inflation in Pakistan is related with volatility in government
borrowing from central bank in the long run. But in the short run, inflation is also affected by
volatility in GBCB [Government borrowing from Central Bank]. (Haider & Safdar, 2007).
There are several theories to explain the relationship between inflation and deficits transmission
mechanism, mainly including the following which Present evidence empirical literature relevant
to this concept.
An immense literature available on fiscal vis-a -vis monetary determinants of inflation.
Therefore, many economist intend to categorize the literature for Pakistan into two sets
including studies which used government borrowing as a determinant of inflation and those
which have not incorporated this determinant in their model setup. (Haider & Safdar, 2007).
Budget deficit (BD) weekly causes inflationary pressures, but rather impacts strongly on
general price level through the impact on money aggregates (say, M1 and M2) and public
Far East Journal of Psychology and Business Vol. 5 No. 3 December 2011
53
expectations, which in turn trigger volatility in prices. Since, government borrows from
different sources to finance budget deficits (Sachs & Larrain, 1993).
The central government of any developing country finances their budget deficit through
monetizing process (borrowing from central bank). High monetization leads to higher
inflationary pressure to the economy. Thus borrowing from the central bank is considered as a
leading indicator of domestic inflation. In line with the above phenomenon, the main
motivation of this paper is to assess whether volatility in government borrowing the main
reason of fiscal deficit has an impact of domestic inflation in Pakistan. (Haider & Safdar, 2007).
Ache, Asif Idrees and Khan Muhammad Salem (2006) used empirical approach of Jhansen
cointegration analysis and VCEM model take CPI as the dependent variables and regressors are
consolidated fiscal deficit and total bank borrowing take sample period of 1973-2003 Findings
are “The empirical results suggest that in the long run inflation is not only related to fiscal
imbalances but also to the sources of financing fiscal deficit”.
S K Hyder and Ahmed, Q Masood (2006) used empirical approach OLS (ordinary least square)
method and verifying results through Breusch Godfrey Serial Correlation LM and augmented
Dickey fuller tests CPI as the dependent Variable, Regressor government sector borrowing (Plus
NFA and other items) as the ratio to real GNP, real demand relative to real supply, on-
government sector borrowing (plus borrowing of autonomous bodies) as ratio of real GNP, price
index of imports and exchange rate, government taxes as the ratio of manufacturing sector value
added, lagged CPI and support price of wheat take sample period of 1972-2005 Findings “The
most important determinants of inflation are adaptive expectations, private sector credit and
rising imports prices whereas fiscal policy contribution to inflation was minimal. Specifically if
government sector borrowing as the ratio to GNP changed by 10% then the resulting change in
CPI will be around 1%”.
Aslam and Anjum, S Waseem (1996) used empirical approach of sustainable deficit econometric
model for Pakistan is estimated, Dependent variables growth rate of GNP, inflation rate, interest
rate of foreign debt etc, Regressors a number of assumptions regarding growth rate of GNP,
inflation and interest rate on foreign debt. Taken three time periods 1980’s, 1985-95 and 1993-
98, Findings “throughout the period under analysis, fiscal deficit was not sustainable”.
Aslam and Ahmed Naveed (1995) used empirical approach of simultaneous model and OLS i.e.
regressions of money supply equation, real cash balance equation, price equation and output
equation and export supply equation. Dependent variables CPI,money supply, demand for real
cash balances, exports.Regressors (1) money supply equation-international reserves, domestic
financing of budget deficit including banking and non-banking system, commercial banks credit
to private sector(2) demand for real cash balances-income, proxy for cost of holding real
balances(3) price-equation income, money supply, import price. Taken three time periods 1973-
92, 1973-82 and 1982-92, Findings “Domestic financing of budget deficit; particularly from the
banking system is inflationary in long run. Money supply is not exogenous, rather it depends on
the position of international reserves and fiscal deficit and it has emerged as an endogenous
variable”.
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Zulfiqar and Sardar (2004) used empirical approach of VAR and regressors CPI inflation, WPI
inflation, PR/USD, M2, LSM index, oil prices. Sample periods 1988:1 to 2003:9. Findings
“Little exchange rate pass through to domestic CPI inflation”. Ehsan U and Mohsin S. khan
(2002) used empirical approach of single equation and VAR in first differences OLS. A
dependent variable CPI and WPI.Regressor US dollar exchange rate, foreign price index. Sample
period was 1982-2001 and Findings “there is no exchange rate pass- through to domestic prices”.
Ahmed, Eatzaz and M Munir (2000) used empirical approach of Cointegration analysis.
Dependent variables are M1 and M2.Regressors index of industrial production, interbank call
money rate, CPI inflation. Sample period 1972:1 to 1996:1.Findings “Inflation is the better
measures of opportunity cost than interest rate, money demand adjust sluggish, and there was a
structural break in the early 1990’s”.
Ahmed, Eitzaz and Saima Ahmed Ali (1999a) empirical approach used single equation use Engle
Granger cointegration test, 2- equation with 2SLS. Dependent variable CPI and exchange
rate.Regressors Exchange rate, import prices, world prices, money supply, GDP, forex
researves.Sample period (1982: ii: 1996: iv).Findings “CPI reacts to change in import prices (due
to change in world prices or exchange rate) and money supply. Exchange rate responds to
domestic and world prices”. Hussain, Akhter (1994) used empirical approach Engel/Granger 2-
stage, Johenson.Dependent variables M1 and M2.Regressors GDP, yield on government bonds,
market call rate, and CPI inflation. Time period 1951-1991.Findings “Meaningful cointegration
relationship (money demand function) for the post -1972 period”.
Khan Ashfaque H (1994) used empirical approach Engel/Granger 2-stage.Dependent variable
M1 and M2.Regressors real income, real interest rate(short term and medium term),nominal
interest rate(short term and medium term),Inflation. Time period (1971: iii to 1993: iii).Findings
“Cointegration relationship between M2 (and M1) and real income and real interest rate,
inflation”. Ahmed, Eitzaz, and Harim Ram (1991) used empirical approach OLS.Dependent
variables WPI, CPI, GNP deflator and absorption deflator inflation.Regressors real GNP growth,
growth rate of unit value of imports, growth rate of M1/M2, lagged inflation. Time period 1960-
1988 Findings “Inflation is determined by real GNP growth, unit value of import growth,
nominal money growth and lagged inflation”.
Chaudry, M Slam, and Naveed Ahmed (1996) used empirical approach OLS. Dependent variable
CPI inflation. Regressors broad money, GDP growth, share of service sector, public debt and
import prices. Time period 1972-1992.Findings “Inflation results from money growth and
structural factors such as growth, share of service sector, imports and public debt”.
ECONOMETRICS METHODOLOGY
The long run relationship between the inflation and budget deficit is examined using
Cointegration technique and the short-run adjustment between the budget deficit and inflation to
account for the long run relationship is examined using Error correction model. Engle and
Granger (1987) proposed a straightforward test whether two I (1) variables are cointegrated of
order CI (1, 1). By definition, of cointegration necessitates that the variables be integrated of the
same order. Thus, the first step in the analysis is to pretest each variable to determine its order of
integration. The Augmented Dickey Fuller test is used to infer the number of unit roots (if any)
Far East Journal of Psychology and Business Vol. 5 No. 3 December 2011
55
in each of the variables. If both the variables {Yt} and {Xt} are I (1), then the long run
relationship is estimated in the form of
In order to determine whether the variables are actually cointegrated, the residual sequence from
this equation is tested for unit roots using Augmented Dickey Fuller test. The rejection of null
hypothesis implies that the residual sequence is stationary and thus the series is cointegrated of
order (1, 1). If the variables are cointegrated, the residuals from the equilibrium regression can be
used to estimate the error correction model given by the optimal lag length to be used in the error
correction model has been determined using SBC criterion.
EMPIRICAL RESULTS AND DISCUSSIONS
In order to examine the long run relationship between the budget deficit and inflation rate using
cointegration technique, both the variables have to be integrated of the same order. An
Augmented Dickey- Fuller (ADF) test is employed to test for unit root. The results of
Augmented Dickey-Fuller test are presented in Table 1. Therefore, the basic necessary condition
for co-integration is satisfied.
TABLE – 1 UNIT ROOT TEST:
SR.NO
LEVEL
1ST
DIFFERENCE
OUTCOME I (1)
LCPI
-3.3083
-3.6302
I(1)
LBD
-3.179203
-8.7165
I(1)
At level both variables LCPI (Log of consumer price index) and (Log of BD) are non stationary
at 5% level of significance and become stationary at 1st difference. Hence both variables are
integrated of order 1 which justifies the use of Engel-Granger approach to co-integration.
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TABLE – 2 GRANGER CASUALITY TEST:
Long length are selected on the basis of AIC and SBC criteria, table 2 show that CPI causes
budget deficit and budget deficit causes CPI.Result show that there is bidirectional causality in
both variables.
Table - 3 (a): Cointegration Test
Dependent Variable: LBD(log of budget deficit)
Variable Coefficient Std. Error t-Statistic Prob.
LCPI* 1.644033 0.073206 22.45748 0.000
C 4.608836 0.272641 16.90439 0.0000
AR(1) 0.561215 0.124555 4.505763 0.0001
R-squared 0.98363
Adjusted R-squared 0.982868
Durbin-Watson stat 2.007055
TABLE - 3 (b)
Null Hypothesis: U2 has a unit root
t-Statistic Prob.*
Augmented Dickey-Fuller test statistic
-
7.945747 0.0000
Test critical values:
1%
level
-
2.618579
5%
level
-
1.948495
10%
level
-
1.612135
Pair wise Granger Causality Tests
Null Hypothesis: Obs F-Statistic Probability
BD does not Granger Cause CPI 45 11.304 4.80E-06
CPI does not Granger Cause BD 7.73789 0.00013
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*LCPI: log of consumer price index
Regress CPI on BD, the coefficient of BD is positive and highly significant. Which show that
BD. positively affect the prices in Pakistan over the period reviewed and error term obtained
from the above regression is stationary at that level, implies that there does long run relationship
Between BD and CPI.Cointegration exist between CPI and BD.
Inflation, GDP growth, and Budget deficit ratio to GDP growth:
YEARS
INFLATION GDP GROWTH BDGDP
1960’*
1970's*
3.30
11.76
6.44
5.08
4.08
5.19
1980's* 7.27 6.42 4.99
1990,* 9.72 4.98 5.28
2000 4.37 3.90 5.28
2001 3.15 2.00 4.09
2002 3.29 3.10 3.62
2003 2.91 4.70 3.62
2004 7.44 7.50 2.34
2005 9.06 9.00 3.34
2006 7.92 5.80 4.28
2007 7.80 6.80 4.34
2008 20.30 7.20 7.42
2009 20.77 3.60 5.20
2010 11.49 4.40 4.90
*Shows the average of ten years
Source: World Development Indicator (2009-10)
This table shows the average trend of inflation, GDP (gross domestic product) growth and
BDGDP (budget deficit ratio to GDP) in the years of 1960’s, 70’s, 80’s and 90’s and the trend
between the years 2000-10.
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Inflation and Budget Deficit Ratio to GDP GROWTH [BDGDP]
(1960-2010)
Source: World Development Indicator (2009-10)
During the period of 1970’s 80’s and 90’s the average of budget deficit remains within the range
of 4 to 5% of GDP.In the period of 2000-05 BD remains stable and 2006-07 it increases it may
due to high foreign capital inflow because of Pak-US ties on war and terror, price shocks, global
financial situation, law and order situation in the country. Starting in early 2007, as international
oil prices continued to rise steadily, basically for political reasons the Musharraf government
decided to abandon the domestic oil pricing formula, and the increases in international oil prices
were not passed on to the public. As the result, the government subsidy bill ballooned and the
BD jumped from 4% of GDP in 2007 to 7.4% in 2008 in its peak. This fiscal deficit was
financed mostly by SBP,to the tune of Rs 650 billion(nearly $10 billion).Effectively this
amounted to printing money to finance the fiscal deficit, and the two well known consequences
of such a policy are inflation and the loss of the researves.This is exactly what happened.
Inflation which was already rising because of the increase in food prices, jumped to over 20% in
2008, almost triple the 2007 rate, and the country lost nearly $6 billion in international reserves
between June 2007 and June 2008.In 2009-10 this trend continuous, as from the graph as
inflation increase BD also increases.
-5.00
0.00
5.00
10.00
15.00
20.00
25.00
30.00
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
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91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
20
09
Inf BDGDP
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GRAPH OF INFLATION AND GDP GROWTH (1960-2010)
Source: World Development Indicator (2009-10)
Inflation is inimical to long term growth, it obviously follows that SBP should aim to the low
rate of inflation. There are several empirical studies now provide convincing evidence that the
relationship of inflation and growth is non-linear in nature. More specifically, at low levels of
inflation the relationship can be positive or nonexistent while at higher rates it become negative
as in 1970’s, 80’s and 90’s the average of inflation goes to increase the growth decreases
drastically. There are negative relationship between inflation and GDP growth. In principle, it is
possible to estimate the threshold level of inflation at which the sign of the inflation-growth
relationship positive (or zero) to negative.Sarel (1996) estimates the the threshold level of
inflation to be in the 8 to 10% range. Below the threshold inflation rate of 8 %, inflation has no
significant effect on growth as in 1980’s when inflation is about 7% it has no significant effect
on GDP growth, but when its get above 8-10% the effect is negative and statistically significant
as in 1990’s when inflation reach above 8% i.e., 9.72 % the GDP growth declines from 6 to
4%.Mubarik(2005),using time series data over 1973-2005 finds that inflation higher than 9%
harms growth in Pakistan, And Hussain (2005) on the other hand , threshold to be between 4-
6%.In 2004-05 the trend almost the same as in relationship of inflation and GDP growth. It
shows also the negative relation in 2008-10.
-5.00
0.00
5.00
10.00
15.00
20.00
25.00
30.00 1
96
1
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
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91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
20
09
Inf GDP GRO
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Graph of Budget deficit ratio to GDP growth [BDGDP] AND GDP growth rate (1960-2010)
Source: World Development Indicator (2009-10)
As BDGDP decreases GDP growth increases. And GDP growth in Pakistan has fluctuated
significantly over the years. If in one decade the country was categorized as fastest growing in
the region, than on other decade it lost those gains. During 1970’s, the 1971 war has badly
affected the economy. Consequently, economy went into recession in1970’s.Seperation of East
Pakistan, nationalization of Industries, financial and other institutions accompanied with
worldwide recession caused by oil crisis were some of the major causes for the high BD and low
GDP growth. During 1970’s the average of GDP growth was 5.08% while the average of
BDGDP was 5.19%.1980’s is the decade of revival of GDP growth as the average of 6%.This
growth rate has been achieved by promoting private sector, denationalization and deregulation of
industrial sector combined with stimulating the workers remittance flow and increased capital
flows due to participating in Afghan War. During the last decade of twentieth century Pakistan
faced severe fiscal imbalances. Because of Nuclear test in 1998 different sanctions have imposed
on Pakistan, Debt burden reached its peak. Moreover during the whole decade there was political
uncertainty in the country. For these reason the average of BDGDP was 6% while the average of
GDP growth was almost less then twice. During 2000-05 the BDGDP decreases and GDP
growth increases. However, at the present due to electricity crisis, terrorism, rising prices of oil
and food commodities, increasing current account deficit, worsening law and order situation and
worldwide recession the GDP growth declines, while BDGDP increases. And Pakistan economy
lost its overall growth momentum.
-2
0
2
4
6
8
10
12 1
96
1
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
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79
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91
19
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19
95
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19
99
20
01
20
03
20
05
20
07
20
09
GDP GRO BDGDP
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61
FINDINGS
History of Pakistan has often witnessed that government’s resorts to seignorage at time of fiscal
distress. It should therefore come as no surprise that much of the contemporary macroeconomics
literature has focused on fiscal behavior when trying to explain why inflation has varied so
widely, both across countries and over time, in recent decades in Pakistan. Fiscal deficit is
considered one of the major determinants of inflation, in the inflation literature of Pakistan.
Increasing fiscal deficits is a persistent problem faced by Pakistan. This research finds that fiscal
dominance hypothesis in determining inflation in the case of Pakistan economy. In connection
with this hypothesis, the results depict important information that the impact of government
borrowing which is the main reason of fiscal deficit from central bank on domestic inflation is
economically and statistically significant. Further, the empirical evidence suggests that there is a
strong long run relationship between domestic inflation and volatility in government
borrowing from central bank. In particular, it suggests incorporating the trend effects of
government borrowing from monetary authorities in inflation modeling. Finally these findings
may help in understanding inflation experience in Pakistan.
CONCLUSIONS
Our empirical results show that there is positive long run relationship LBD (Log of budget
deficit) and LCPI (Log of consumer price index).BD (budget deficit) causes Inflation i.e. BD is
the important determinant of Inflation. This paper sought to address the issue of fiscal deficit and
its impact on inflation. On the other hand there is much more favorable to fiscal based theories of
inflation than previous research had found. The deficit-inflation relationship comes out as
surprisingly strong in Pakistan, also in contrast with the earlier literature. From Engel-Granger
cointegration test there exist a long run relationship between BD and CPI.There is cointegration
between BD and CPI.
If the government of Pakistan is allowed to continue the size of deficits and debt to expand, then
the resulting rise in interest rates will force the central bank buying government bonds through
open market operations to maintain the level of interest rates, while the end result of this
approach will enable the currency increasing supply and eventually lead to inflation from
happening. In addition, when the size of fiscal deficit and national debt accumulated to a certain
extent, the Government's sustainable conditions for the credit will be broken, once the
Government, through the bonds can not be expected to achieve results, then it can only rely on
seigniorage to make up for all of the budget deficit, then the same will eventually lead to the
occurrence of inflation in Pakistan.
Recommendations
Therefore, the future, our government should follow the following two aspects at least do a good
job on the budget deficit inflation risk, prevention work: first, to strengthen the independence of
the central bank, clear the central bank's monetary policy objectives. Right to give a legal
guarantee for the independence of the central bank will help cut the budget deficit and the money
supply of the internal relations, thereby limiting the Government directly through the central
bank the possibility of an overdraft to cover the deficit. Therefore, our government should
present the implementation of prudent fiscal policy as an opportunity, through the establishment
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of a sound modern tax collection system, optimize the Structure of government spending and
speed up the reform of budget management system and other means to create conditions for the
gradual reduction of fiscal deficit.
Future Gap
The empirical results suggested that fiscal imbalances and weak forecaster for future
inflation in economies under study. More specifically, they found that the predicted rise in fiscal
deficit scenario in future could possibly impact in an insignificant manner towards
increasing inflation in the economy. The authors further observed that their results should be
used with much caution as econometrically evaluating the inter-temporal budget constraint is
vulnerable to non-stationary and time dependence problems.
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