Chapter 13. Low-Income Countries

Tobias Adrian, Douglas Laxton, and Maurice Obstfeld
Published Date:
April 2018
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Rahul Anand Andrew Berg and Rafael Portillo

This chapter is based on the work done at the IMF on monetary policy regimes in low-income countries. In particular, it draws heavily from Berg and Portillo (2018). It also draws on our work on IMF policy papers on the topic, notably IMF (2015) and on our engagement with central banks in Africa and Asia (Uganda, Kenya, Tanzania, Sri Lanka, and so on) on building their capacities for forward-looking monetary policy analysis and implementation.

The farmers care a lot more about the rain than they do about interest rates. But the central bank has a lot more influence over the interest rate than it does over the rains. —Anonymous African central banker

In recent decades, many central banks in low-income countries have succeeded in reducing inflation to single digits while also deepening their financial markets and achieving high growth, the result in no small part of better macroeconomic management. Monetary policy has gained traction due to increased central bank independence, reduced fiscal dominance, and greater reliance on market-based procedures. More recently, though, policymakers in low-income countries have begun to ask that monetary policy do more than achieve a basic degree of stabilization.

This ambition is stymied by the general lack of clear and effective monetary policy frameworks, which impairs central banks’ ability to steer financial conditions, respond appropriately to shocks, and avoid policy misalignments. Many central banks are therefore in the process of modernizing their policy frameworks to address these limitations. To further enhance their ability to anchor inflation and inflation expectations and to promote macroeconomic and financial stability, many of these central banks are moving toward more flexible and forward-looking frameworks for formulating, implementing, and communicating monetary policy.

The factors that contribute to the success of inflation-forecast-targeting regimes, as documented in previous chapters of this book, provide useful lessons for central banks in low-income countries that seek to improve their monetary frameworks. At the same time, these central bankers face unusual monetary policy challenges, such as relatively small financial systems and a heavy dependence on agriculture and commodities.

This chapter charts a way forward for monetary policy in low-income countries, drawing on the IMF’s experience in helping build capacity in these central banks, notably in establishing forecasting and policy analysis systems. The discussion draws heavily on the experience of countries in sub-Saharan Africa, but the issues are broadly similar across low-income countries. Furthermore, monetary policy issues in low-income countries differ in degree—but not fundamentally in kind—from those of more developed countries.

The Evolution of Monetary Policy in Sub-Saharan Africa

Starting in the mid-1980s and through the late 1990s many countries in sub-Saharan Africa began economic reform programs that often included the unification of multiple exchange rates; a movement toward more market-determined, flexible exchange rates; and the dismantling of exchange and trade controls. The conditions prevailing at the start of these programs (that is, heavily managed or even de facto pegged exchange rates, pervasive capital controls, and fiscally driven monetary policy) explain the appeal of such a monetary policy framework, anchored on control over money financing of the fiscal deficit.

Other key elements of this two-decade transition were sharp reductions in central bank financing of government and financial liberalizations that eliminated interest rate controls and introduced competition into the banking sector. The reestablishment of fiscal control provided support for the introduction by the late 1990s of money-based programs to bring down inflation to (or near) single digits in the context of higher economic growth and higher international reserves, in line with the experience of other developing countries. The liberalization of direct controls over the commercial banking system helped alleviate the prolonged financial repression (Adam and O’Connell 2005).1 These developments also coincided with greater use of open market operations by central banks in the region. All of these developments had the effect of increasing the role of market signals and the importance of managing expectations in the implementation of monetary policy.

By the early 2000s, then, countries such as Ghana, Kenya, Nigeria, Tanzania, Uganda, and Zambia were beginning to enjoy sustained growth with low and stable inflation (see, for example, Kessy, O’Connell, and Nyella 2016). Macroeconomic stability was increasingly accompanied by the deepening and development of domestic asset markets and, in some cases, by moves to liberalize the capital account to encourage greater private capital inflows, including into sovereign debt.

The reduced role for the exchange rate as a nominal anchor and increasingly developed financial markets revealed weaknesses with existing policy frameworks. In particular, the money-targeting regimes did not provide effective frameworks for formulating and implementing policy. At the same time, the ambition grew for monetary policy to promote smoother functioning of interbank markets, to provide clearer interest rate signals, and more generally to play a greater stabilizing role.

Challenges for Monetary Policy in Low-Income Countries

Undertaking to modernize the monetary policy frameworks in low-income countries requires a reasonably accurate view of how these economies work. Standard macroeconomics does not fully capture the situation in low-income countries given that it was developed based on the experience of fairly stable institutions and consistent data series and thousands of research papers in advanced economies and more recently in emerging markets. Low-income countries face specific characteristics and challenges that influence the way in which their central banks conduct monetary policy.

The Monetary Transmission Mechanism

There are many reasons to think that the transmission mechanism in low-income countries may be different. Low-income countries have shallow financial markets, so that changes in financial conditions brought about by monetary policy may directly affect a smaller share of the population (Table 13.1). Furthermore, the nature of the policy itself decisively shapes the nature of transmission, and the opacity of existing frameworks may undermine the effectiveness of policy. Where exchange rates are heavily managed, or the capital account is closed, transmission through exchange rates is also likely to be attenuated. Moreover, reviews of the empirical literature (mostly based on vector autoregressions, VARs) have had difficulty finding a clear transmission mechanism (Mishra and Montiel 2012).

Some policymakers and researchers conclude from this assessment that the transmission mechanism is weak or even nonexistent (see Mishra, Montiel, and Spilimbergo 2013, for example). However, much of the empirical evidence may result in part from difficulties in applying standard empirical approaches to low-income countries rather than a lack of underlying transmission. Typical features of low-income country data, including short sample lengths, measurement error, and frequent policy regime changes, can greatly reduce the power of VARs to uncover the monetary transmission mechanism (Chapter 6 of Berg and Portillo 2018).

In addition, the policy regime itself strongly shapes transmission, in addition to and sometimes in lieu of deeper structural factors. Monetary policy relies on a clear understanding from financial market participants of current and likely future actions by the central bank, and existing arrangements in low-income countries make such a clear understanding difficult; the combination of money target misses, noisy short-term interest rates, and incipient communications makes it difficult to assess policymakers’ intentions. Under these conditions, monetary policy decisions have a smaller impact on longer-term rates, inflation, and output than they do under interest-rate-based frameworks, even when policy intentions are the same and even when the underlying economic structure is supportive of monetary policy effectiveness.

Table 13.1.Financial Sector Indicators: Low-Income Countries versus Other Economies
GroupCredit to the Private Sector (Percent of GDP)Bank Credit to the Private Sector (Percent of GDP)Five-Bank Asset Concentration (Percent)1Stocks Traded, Total Value (Percent of GDP)Dollarizatioin2Chinn-lto Financial Openness Index3
Low-Income Countries19.618.880.04.912.8−0.4
Emerging Market Economies60.949.169.626.64.00.3
Advanced Economies145.3133.784.870.20.52.2
Sources: Data is 2011 World Bank data except as noted; and IMF staff estimates.

Assets of five largest banks are shown as a share of total commercial banking assets.

Foreign currency deposits are shown as a share of total deposits in the banking system.

Index values are for 2010. The index takes a maximum value of 2.5 for the most financially open economies, and a minimum of —1.9 for the least financially open (see Chinn and Ito 2008).

Sources: Data is 2011 World Bank data except as noted; and IMF staff estimates.

Assets of five largest banks are shown as a share of total commercial banking assets.

Foreign currency deposits are shown as a share of total deposits in the banking system.

Index values are for 2010. The index takes a maximum value of 2.5 for the most financially open economies, and a minimum of —1.9 for the least financially open (see Chinn and Ito 2008).

A study of the effects of a dramatic tightening in monetary policy in the East African Community in 2011 finds a well-functioning transmission mechanism, especially in those countries where the stance of monetary policy was communicated clearly. It also finds that the depth of financial markets is a less clear indicator of the strength of transmission than of the clarity of the regime (Chapter 5 of Berg and Portillo 2018).

It still may be that transmission in low-income countries is generally weaker and more uncertain than in other countries, which would caution against trying to fine-tune monetary policy. However, this point can easily be overemphasized. First, deep uncertainty about the transmission mechanism is not unique to low-income countries but rather is a general characteristic, perhaps especially of countries implementing new policy frameworks, often in the face of rapid structural change or financial crises. Second, this does not justify inaction. Indeed, weak transmission may explain the much larger policy movements that are often observed in sub-Saharan Africa.

Supply Shocks and Macroeconomic Volatility

The economies of low-income countries are typically commodity dependent in terms of both domestic production and trade and are thus dominated by supply shocks (Table 13.2). Indeed, it is difficult to identify a Phillips-curve-type relationship in the data because of the dominance of supply shocks, which tend to generate a negative correlation between the output gap and inflation in low-income countries (Figure 13.1). Many of these supply shocks call for adjustments to the real exchange rate. In general, developing economies with more flexible exchange rate regimes do a better job of shielding their economies from the effects of these shocks, thanks to the shock-absorbing role of the exchange rate.2

Table 13.2.Economic Structure: Low-Income Countries versus Other Economies
GroupExports (Percent of GDP)Imports (Percent of GDP)Aid (Percent of GDP) %%Rural Population (Percent of total)Commodity Exports (Percent of exports)1
Low-Income Countries28.348.413.169.264
Emerging Market Economies42.241.41.834.527.9
Advanced Economies65.561.0020.519.5
Source: Organisation for Economic Co-operation and Development; World Bank; and IMF staff estimates.

Includes exports of food, agricultural raw materials, and ore and minerals (2011 data).

Source: Organisation for Economic Co-operation and Development; World Bank; and IMF staff estimates.

Includes exports of food, agricultural raw materials, and ore and minerals (2011 data).

Figure 13.1.Correlation between Inflation and the Output Gap, by Level of Income per Capita

Sources: Haver Analytics; Organisation for Economic Co-operation and Development; World Bank Development Indicators; and IMF staff estimates.

1 Income per capita (2012) is normalized by income per capita for the United States.

Shocks to international food and fuel prices pose an additional set of challenges. In the African context, food makes up a large share of the consumer basket, so that the direct impact of food price shocks is larger. In addition, sub-Saharan African countries are net food importers on average, and many are net oil importers, so that the inflationary impact from higher international prices could be compounded by the real and nominal depreciation required for external adjustment (see Adam 2011; Chapter 11 of Berg and Portillo 2018). These shocks have therefore been a source of inflation pressures; at the same time, the direct effect of these shocks may mask underlying monetary policy misalignments that can amplify the overall inflationary effect (see Chapter 15 of Berg and Portillo 2018, for example).

Domestic supply shocks are an even larger source of inflation volatility. This is because the agricultural sector is heavily exposed to weather-related shocks. One implication is that inflation is inevitably more volatile in low-income countries, with the larger volatility reflecting supply-side changes to relative food prices. Much of this volatility is unlikely to disappear even as countries modernize their policy frameworks.3

Traditionally less open to foreign capital, many low-income countries have substantially opened their capital accounts in recent decades, significantly exposing them to a full range of external shocks. Given that international aid inflows can be large and unpredictable, this creates difficult challenges both for fiscal policy and for monetary policy (Table 13.2).4

Fiscal Policy as a Source of Volatility and Pressures on Monetary Policy

Fiscal dominance—where the need to finance the government deficit through money printing determines the rate of inflation—remains a fundamental challenge to monetary policy in only a few countries in sub-Saharan Africa. In a much larger group of countries, however, fiscal policy can greatly complicate the conduct of monetary policy. Central banks in Africa must contend with highly volatile and procyclical fiscal policy. Sometimes the source of fiscal volatility is a high dependence on revenues from the commodity sector and the lack of binding fiscal rules to ensure intertemporal smoothing. In other cases, fiscal procyclicality stems from the political cycle. Certain features of African economies, for example, the large share of the population that lives on their current income, amplify the effect of these shocks on aggregate demand.

Even if fiscal dominance is a (not-so-) distant memory, the volatility and procyclicality of fiscal policy creates other forms of fiscal pressures on monetary policy. One stems from the cost of monetary operations.5 This is a source of contention with the government, particularly where the financial system is in a situation of structural liquidity surplus, for example, due to sizable interventions in foreign exchange markets, and a legacy of quasi-fiscal operations have left the central bank with low or negative net worth. In this case sterilization operations, which are necessary to maintain an appropriate policy stance, can have sizable effects on central bank profits.

Another type of pressure occurs when the central bank tightens policy less aggressively out of concern for the effect on fiscal solvency. This may be one possible reason why many central banks in sub-Saharan Africa have yet to formally adopt interest-rate-based frameworks and why those that do often implement changes to the policy stance without changing the more visible policy rate.

The Current Monetary Policy Landscape

Many policy changes have been institutionalized in sub-Saharan Africa through reforms that have cemented central bank independence and through the adoption of new central bank charters. Most of the region’s central banks have a de jure (legislated) independence, and their de facto independence score (0.26) has been on average very close to the developing countries’ average (0.25), using the measure in Lucotte (2009).6 The de facto policy regime in most countries is best characterized as a hybrid regime. An overview of the objectives and targets of monetary policy in the region reveals a set of managed floaters with a variety of conventional-looking objectives (price and exchange rate stability), but with money aggregates still present as both operational and intermediate targets.

Price Stability, the Medium-Term Inflation Target, and the Pursuit of Other Objectives

Most central banks in sub-Saharan Africa have bought into the idea that price stability is the primary goal of monetary policy, at least de jure. In many countries, however, the primacy of price stability remains to be established. Most central banks without inflation-targeting regimes do not have an explicit inflation objective, and those that do tend to adjust the objective in line with changes in the near-term inflation forecast, which reduces its anchoring role. Many central banks continue to pursue other objectives, for example, supporting growth, deepening the financial sector, or improving external competitiveness. This multiplicity of objectives and the lack of a clear hierarchy among them typically results in erratic policies, although to a smaller degree than in the past: the monetary stance is loosened, for example, to support financial deepening, only to be tightened later once inflation pressures appear.

This state of affairs is most visible in the central role that the exchange rate plays in policy frameworks of many countries in sub-Saharan Africa, including those with de jure exchange rate flexibility. Though some attention to the exchange rate is inevitable given its importance for inflation dynamics, in some countries exchange rate stability often takes precedence over price stability. The exchange rate is the de facto anchor, at least temporarily, and operations aimed at influencing the exchange rate end up determining the stance of policy, for example, through the use of unsterilized interventions in the foreign exchange markets. Of course, this is a feature of many emerging market economies as well, although it features more prominently in low-income countries (Figure 13.2).

Figure 13.2.Intervention to Foreign Exchange Market Index in Low-Income Countries and Emerging Market Economies1

Sources: IMF International Financial Statistics; and IMF staff calculations.

1 Following Levy-Yeyati, Sturzenegger, and Gluzmann (2013), the index is calculated as the annual average absolute change in net international reserves relative to the monetary base in the previous quarter, both in US dollars.

Operational Frameworks

Low-income countries of sub-Saharan Africa use reserve money targeting as the de jure operational framework of choice, in contrast with the now standard practice of setting operational targets on (and controlling) very short-term interest rates adopted by most advanced and emerging market central banks.7

Money targeting is implemented very flexibly, with frequent economically significant misses of money targets. These misses mainly seem to represent accommodation of money demand shocks, although some may involve policy shifts. Flexible implementation of money targeting is also evident in the process of adjustment after misses. In “textbook” money targeting, where a constant growth rate of money serves as the nominal anchor, deviations from targets would be undone in subsequent quarters as the actual stock would be brought back to the predetermined target path. This does not seem to be what happens, however. Rather, the new targets themselves tend to accommodate, at least partly, deviations from previous targets. There is no sign that actual money growth itself moves to reduce earlier deviations from target. There is also little sign that inflation responds to these misses, at least in countries with inflation below the mid double digits.

More recently, many central banks have introduced policy rates to signal the stance of policy, but deviations between policy and actual rates are common, and tensions between money targets and interest rate policy are inevitable. Reserve money targeting can lead to highly volatile short-term interest rates, as the authorities respond partially and unpredictably to money demand shocks.8 In addition, tensions between money targets and desired interest rate outcomes frequently lead to complex regulations and interventions in short-term financial markets and a multiplicity of short-term interest rates. All this discourages financial market development (IMF 2015).

In addition, reserve money targeting makes the stance of policy noisier and more difficult to interpret on the part of both financial market participants and the central bank itself. Not all money demand shocks are accommodated, so that interest rates are a volatile and noisy indicator of the current and expected stance of policy. Greater de facto flexibility relative to money targets reduces this volatility but at costs of greater discretion and opacity about the true operational framework. Of course, not all deviations from target represent accommodation of money demand, but it is very hard to tell in any particular situation. The effectiveness of the operational framework is hampered as a result (see Chapters 8, 9, and 16 of Berg and Portillo 2018).

An additional layer of complexity is brought about by recurrent interventions in foreign exchange markets, which are the main tool for managing the exchange rate in most sub-Saharan African countries. There is often insufficient coordination between interventions in foreign exchange markets and other operations. As a result, interventions influence the stance of policy in unintended and undesired ways.

Given all this flexibility, and given the difficulty of inferring the stance of policy from the money targets or target misses and the failure of money targeting itself to provide a nominal anchor, how can these policy regimes be understood? The answer seems to be that these countries tend to practice an opaque version of “inflation targeting lite,” in which decisions about the setting and achievement of the money targets depend on progress relative to inflation, output, exchange rates, and in many cases other objectives (see Stone and Bhundia 2004).

Modernizing Monetary Policy

Central banks in sub-Saharan Africa are well aware of the limitations of their existing frameworks and are looking to improve along the various dimensions we have discussed. Ghana was an earlier adopter of inflation targeting. Uganda was next in line. Outside of sub-Saharan Africa, the Sri Lankan central bank has publicly announced its commitment to adopt inflation targeting. Several other central banks, including Kenya, have explicitly discussed the possibility, even if they have yet to formally commit. Many other countries, while not explicitly considering the move, are working to improve their operational framework by giving more prominence to policy interest rates, and by improving on the design and use of open market operations and standing facilities.

Although there is no one-size-fits-all approach to monetary policy modernization, central banks can learn from the experience of many countries outside sub-Saharan Africa, as well as from early movers within the region. One key lesson is that progress is not possible without sufficient operational independence nor with a sufficiently clear central bank mandate for price stability, even if adherence to these two principles is always a work in progress. Building and maintaining political commitment are therefore critical. The central bank has a leading role to play in building the necessary consensus for reform.

Another lesson is that central banks can make progress in many areas simultaneously. Progress can be self-reinforcing: the development of analytical capacity is more likely to impact policy making if it is consistent with the way policy is designed and implemented, which requires clarity about the strategy and the operational framework. The adoption of an explicit numerical objective can provide impetus to investing in analytical capacity and the communication strategy, while an effective operational framework can make central banks more comfortable about explicitly committing to an inflation objective. These synergies call for a comprehensive approach to reform.

A related issue is whether to explicitly adopt a new regime, namely inflation targeting, and if so whether to do so at a specific stage of the modernization process. What the international evidence corroborates, and the above discussion implies, is that countries do not need to satisfy a strict number of preconditions before they can adopt inflation targeting (Batini and Laxton 2007). If anything, the opposite is true. A clear framework is more conducive to reform. This should not be surprising in view of the observation above that current reserve money targeting frameworks already amount to an obscure form of “inflation targeting lite.”

Another critical part of modernization is the development of analytical tools for policymaking and techniques for effective communication. Despite limited availability and reliability of the macroeconomic data in low-income countries, and regardless of the monetary policy framework in place, there is significant room for improvement in macroeconomic analysis of the already available data. Central banks of low-income countries have a great need for models to undertake policy analysis. In our view, these models must meet two criteria. First, they must reflect modern thinking on monetary policy, drawing on both state-of-the-art macro theory and current practice in central banks in advanced and emerging markets. Second, they must be tailored to address key low-income-country-specific issues. Despite the importance of the topic, there has been very little work in the academic and policy literature tailored to low-income countries. Several chapters in Berg and Portillo (2018) review analytic frameworks useful for policymaking in low-income countries.

Forecasting and Policy Analysis System

The efforts involved in deriving and applying these models have led to a more systematic collaboration between the IMF and central banks in low-income countries on the topic of analytical frameworks for policy analysis and forecasting. Partly as a result, several central banks have been developing and using their own variant of these models to organize their internal discussion and forecasting systems.9 This is an important part of the policy modernization efforts and points to the synergies between research, IMF surveillance or program work, and capacity development on the ground.

Besides these challenges, there is a need to gain more experience with using the analytical tools (including core medium-term forecasting models) in low-income countries. Although these tools have proven to be useful in advanced economies and emerging markets, the practical experience with using them in low-income countries is limited so far. Berg and Portillo (2018) present several efforts to adapt these tools to characteristics of low-income countries. However, practical experience from real-time use of these tools to support policy decision-making remains to be built over time.

The Role of the IMF

In response to demand from country authorities (mostly governors of central banks in sub-Saharan Africa), the IMF’s review-based conditionality toolkit was adapted to support countries’ efforts in strengthening their monetary policy frameworks. In 2014, the IMF’s Executive Board approved a new review-based conditionality for programs with countries with evolving monetary policy frameworks that have a good record of policy implementation or are committed to a substantial strengthening of their policy framework through the introduction of a monetary policy consultation clause (IMF 2014). This will help align conditionality in IMF programs to the policy reality in some low-income countries, and strengthen the IMF role as a trusted advisor. The new toolkit is being integrated into IMF-supported programs and Article IV consultations in low-income countries, building on countries’ progress in modernizing frameworks.


Central banks in low-income countries have come a long way. They played a critical role, though perhaps subordinate to fiscal policy, in improving macroeconomic stability. In sub-Saharan Africa, for example, this has helped set the stage for the growth resurgence since the mid-1990s. The challenges, however, seem to be getting tougher. Perhaps foremost is the difficult global economic environment: will low-income countries be able to keep growth going in the face of shocks related to China’s growth slowdown and swings in commodity prices? Are monetary policy institutions strong enough? Have central banks achieved effective enough monetary policy frameworks to adjust to these shocks, keep expectations anchored, and resist political pressures? Much progress has been made and much more is under way. Will pressures expose weaknesses that spur further reforms or rather derail them?

Many of the most serious challenges lie in the domain of fiscal policy and more broadly still in the resilience of a broad range of institutions both public and private. Most of the shocks are real rather than monetary: commodity prices, resource output, foreign direct investment flows, foreign demand, and fiscal policy. However, in our view the agenda for monetary policy outlined here can play a critical supporting role.

Central banks can work to implement clear forward-looking policy regimes that respond coherently to the full range of shocks. This will help avoid macroeconomic and financial crises, allow exchange rate flexibility to avoid persistent misalignments due to commodity price shocks, and keep inflation expectations anchored while avoiding unnecessary swings in interest rates, inflation, exchange rates, and output. All this can keep bad times from exploding into vicious circles of macroeconomic disarray and allow policymakers time to address the full range of challenges.


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For countries in sub-Saharan Africa with available data (and without exchange rate pegs), the financial reform index reported by Giuliano, Mishra, and Spilimbergo (2010) more than doubled on average in the decade between 1985–1990 and 1995–2000. (The countries are Ghana, Kenya, Madagascar, Mozambique, Nigeria, South Africa, Tanzania, and Uganda.)


See Broda (2004) and Edwards and Levy-Yeyati (2005) for evidence on the effect of terms-of-trade shocks in developing countries across exchange rate regimes, and Hoffmaister, Roldos, and Wickham (1998) and Ahmad and Pentecost (2010) for similar analyses for countries in sub-Saharan Africa.


See Anand, Prasad, and Zhang (2015) for a discussion of some of the analytics of food prices and monetary policy.


See Chapter 10 of Berg and Portillo (2018); Buffie and others (2008); and Buffie, O’Connell, and Adam (2010) on the advantages and disadvantages of various policy responses.


Berg and Portillo (2018)Chapter 2 provides a discussion of these issues in the case of Uganda.


Indices of central bank independence combine assessments of tenure protection of central bank’s senior management, operational independence, clearly legally defined objectives for monetary policy, and limits to central bank lending to the government. The construction of the indices is based on the methodology outlined in Cukierman (1992) for de facto independence and Cukierman, Webb, and Neyapti (1992) for de jure independence.


Targets on reserve money are part of a broader monetary programming exercise in which targets are also set for broad money, which is considered an intermediate target of policy. With a few exceptions, however, targets on broad money play a smaller role in policy discussions in practice.


Berg and others (2013) describe the implications of strict money targeting for interest rate volatility in Uganda.


This includes the central banks in Ghana, Kenya, Malawi, Mozambique, Rwanda, Sri Lanka, Tanzania, and Uganda.

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