Consentia on Commerce and Economics

DELEVERAGING – A FARCICAL OR COGNIZANT REALITY?

CHAPTER I- INTRODUCTION[1]

Deleveraging in the most elementary form can be expressed as the exercise of reducing debt by selling off assets. Due to this very nature deleveraging has often been seen as a practice activated only during times of economic losses[2]. While this is most often the case, deleveraging can also prove to be very beneficial to a business as it prevents any further losses and can help leverage an already bleeding wound from hemorrhaging. Deleveraging hence can be defined as the process of repaying debts with the help of available assets to benefit an ailing financial burden or loss.

In a more complicated and economically relevant context deleveraging refers to the reduction of the relative size of the assets to private equity. It is the process of reducing this ratio. [3]While private equity had seen its golden years, American Household Bubble burst and the consequent recession arrested its robust growth.

Hence the unavailability of private sources of equity generation hit the economy. Along with this while the financial sector in the private spectrum was seeing a catalyzing growth with credit to the private sector exceeding 110 % of the United States of America’s national GDP, there was the cycle of huge debts being undertaken by the private sector. Low savings were prominent and deficit spending characterized the economic atmosphere. When the American bubble burst and led to the reign of the catastrophic global financial crisis there was a huge need to let go off such assets to pay debts and this is where the essence of deleveraging lies. In today’s troubled days deleveraging has been seen as the salvaging force of the economy.

Aims and Objectives

This paper seeks to analyze the aspects of deleveraging along with scrutinizing its success and failures by contrasting 4 different economies –Spain, Weimar Republic, United States of America and Japan. This research paper attempts to answer the following questions –

  1. Is deleveraging a universal concept and can it be applied as a thumb rule to all economies?
  2. What are the factors that determine the success of deleveraging?

CHAPTER II- WHY WE NEED DELEVERAGING?

When the economy is growing leveraging accompanies it and helps in financing of projects that would otherwise remain incomplete and unprofitable.[4] On the other hand the same leveraging also shows its uglier side with a market downturn. There is a decrease in the value of the assets created and great pressure to repay the huge debt defaults. Deleveraging is needed to reduce the debts on the balance sheet of a leveraged arty to insulate it from market volatility.[5]

Deleveraging is needed to raise cash to repay debts in a falling market. This can be done either by selling available assets or by increasing capital available. In certain situation both of which are viable[6]. This process can be a very tragic moment for a financial body as it is letting go of assets that could be exercised for credit creation to fund bigger projects. [7]

At the national level deleveraging t is measured according to the decline in the national Gross Domestic Product.[8] Deleveraging at the national level is often accompanied by reducing public spending termed as an “austerity measure “ and has been rejected in economies like the United States of America leading to the Occupy Wall Street Movement .As the Government attempts to reduce its debt it cuts down on its spending and the common man is the first and worst hit.[9]

Another common attempt is to supply more money into the market so as to ensure that there is more market liquidity thereby reducing the debt ratio. If not checked by the government this can unfortunately lead to hyperinflation in which the value of the money to buy a certain good reduces drastically due to an excess supply of cash in the economy.[10] This has not proved to be a very successful deleveraging process in counties like Chile[11] and Zimbabwe. Often when the savings are increased to deal with debt and spending is limited both at the micro and macro level there is a decline in economic expansion, which proves further a recession. This thinking fuels  that one man’s spending is another man’s income and when there is a massive saving drive, there is a lack of available liquid in the economy for any further growth thereby leading to a dwindling spiral. [12]

While deleveraging is the consequence of a series of symbiotic economic transactions failing, it can also prove to bring salvation to an economy thereby making it rise and reach its potential in a period of six to seven years after the financial-crisis..
CHAPTER III- TYPES OF DELEVERAGING PROCESSES

Ugly Deflationary Deleveraging

This process is usually characterized by the economy continuing to be in a pitiable state while the debt and income ratio improves. Here there is a fall in the prices of financial assets but due to the shrunk situation of the economy and individual incomes there is a reduction in the debt and income ratio.  In the economy the private sector is failed to limit the manufacture of its good and services due to the lack of demand because of the unaffordability in the times of a financial crisis[13].

Liquidity is very low in these situations and as a result the private sector begins to shrivel up. This dismal situation is caused when financial institutions both at the micro and macro level calculate the real value of assets and the available money to repay debts in the market. When this is insufficient to service debts, deleveraging of this characteristic in undertaken.[14] As reiterated in this paper there is a symbiotic relationship between the producer and consumer and when one of them reduces his share in this cycle the market is disturbed and in this situation it begins to shrink.

It is the utmost responsibility of the Government fiscal policies to control this debt reduction to ensure it does not slow down the economic transactions at a very fast pace. This is when the governments try to implement their austerity measure plans[15]. In this process the spending of a consumer is further limited thereby reducing the capital available to the producer and overall it does not help the market. This causes a massive deflationary future for the economy and this process has been termed as the Ugly Deflationary Deleveraging process.

Beautiful Deleveraging

This is a more pleasant example of deleveraging that is characterized by the reduction in debt and income ratios along with a growth in the economy. This is usually accompanied by an improvement in the prices of financial assets. [16]Why is this so?

It is possible due to the availability of liquidity in the market. The printing of cash in the market by the Government enables this. It provides for credit support and can thereby keep a check on the deflation in an economically hammered economy. Hence while the reduction of debt is carried on there is also circulation of liquid in the market hence ensuring the economy does not come to a halt.[17] However in this process the value of the currency can reduce as compared to the prices in gold, yet this does not cause hyperinflation as the spiked reflation only merely reduces the deflation in the market. [18]This is possible however only when the amount of cash (liquid) raised by the Central Bank is equal to the amount needed to neutralize the negative credit market collapse so that transactions are encouraged to help the economy.

Ugly Inflationary Deleveraging

This deleveraging process is accelerated by the over printing of currency in a country to neutralize deflation. Over monetization leads to the reduction in the value of the currency and can cause an ugly inflation in the economy.[19] Making thing worse in such situations, the printing of cash is much later in the deleveraging process where markets are already subordinated and the excess printing later on can lead to a deflationary deleveraging. Due to the over printing of currency in the market, its value reduces and causes an inflation during such deleveraging. [20]

CHAPTER IV- ANALYSIS OF GLOBAL DELEVERAGING PROCESSES

·         JAPAN

The Private sector in Japan in 1989 faced a major bubble burst, which is similar to the one, faced by the USA due to the easy availability of loan. There was a decline in the prices of assets in Japan due to this. This led to a real credit crunch in the Japanese Markets to form an acidic bane of economic stagnation in Japan. This was followed by the rise of a Government fiscal expansion operation. Unfortunately this was a protracted affair and it was delayed due to the regulatory authorities of Japan. [21]

Under the Basel Committee to which Japan was a signatory the bank ratio of capital to its risky assets was to be a minimum of 8 percent and it left no space for national economic fluctuations. With the fall of the Japanese stock markets there was a hand in hand falls in the cash available to banks as well. [22]This further made prices of property in Japan fall. Unfortunately there was no printing of currency the central bank or Government. This prevented the nominal interest rates from being higher than nominal interest rates. When printing was undertaken also, it was a very minimal amount and for a limited period of times. This did not help the inflation problem and the burden remained in the economy. Continued deflation has burdened the Japanese economy. However in the private sector things have improved due to real growth and paying of debts (including the interests.)[23]

·         UNITED STATES OF AMERICA

The USA market also faced a similar situation as faced by Japan in 1989. A household bubble burst along with the fall in share prices and major banks added to a bleeding federal cash reserve burdened with the price of waging multiple wars. Yet unlike the depression in America in the 1930’s the economy has waged a better fight this time[24]. The credit for this is to be given to the Federal Reserve Bank of America that has pushed for the printing of cash to be circulated in the American economy. This has helped individual incomes rise and also lead to a growth although very minimal of the economy. This reflation of the economy has also ensured the reduction in debt by a small margin.[25]

Post 2009 due to the reflation made possible by the Federal Funding, for alleviating debt incomes have improved. This in turn has helped the credit markets and due to the presence of credit in the system the private sectors situation has improved. The treasury in the USA has been given credit of this successful deleveraging under which it provided money into the system. [26]Money was pumped in by pushing aggressive easing policies like pumping of money into assets that were risky along with cutting rates at which credit could be borrowed. The Federal bank also bought agency-backed bonds to help this. Government bonds were also bought to pump money in the system until marginal growth rates became a little higher than government growth rates. [27]

·         GERMANY’S WEIMAR REPUBLIC

While waging war in the 1918, Weimar Republic ended in heavy debts and this was to be repaid to the Allied forces in Gold. In the meanwhile the economy began to collapse. It was then that the country decided to print money to save itself. Unfortunately it was quite the opposite as there was an unchecked printing of cash and the value of the currency dropped. [28]This was made worse by the rise in inflation due to fallen value of the currency especially with respect to gold.

This did not help the debt in 1918-1920 as that had to repay in gold. However in 1922, any reparation debts were just stopped from repaying. As a result the currency further devalued and most investors chose to move their money away from banks and the national currency to other safer sources. [29]This made the availability of liquid much tougher and to curb the same money printing was increased by 1.2 trillion percent in this period. This led to a case of massive hyperinflation.[30] The currency absolutely lost its value in this process.

·         SPAIN

Spain is another European country that is heavily indebted and due to its limited resource processing it was very badly hit by the 2008 bubble burst and fall of markets globally[31]. Although the deleveraging process has been comparatively smoother in Spain it is still classified to be an ugly deflationary deleveraging as Spain cannot monetize that is print its own currency to evolve into a beautiful deleveraging.[32] This is due to Spain being a member of The European Union whose currency is decided as a union and not by individual nations. However the ECB has pumped in money to Spain by buying its government bonds. Yet interest rates are not as low for nominal growth to be bigger than the nominal growth rate. Along with this debt reduction in Spain are dependent on the austerity measures.[33]

CHAPTER V- IS DELEVERAGING A UNIVERSAL PROCESS OR IS IT AN INDEPENDENT PROCESS FOR EVERY ECONOMY?

While it may be unfair to state that deleveraging is a universal process that is uniform across the world, it must be noted that in a modern global economy such as ours, every individual economy is interrelated and this makes the process of deleveraging spread across individual economies.  After the recent 2008 bubble burst there has been a huge debt crisis across the globe ranging from Dubai to Iceland to the USA and Greece.

Another common aspect of the same is that post the 2008 crisis, most indebted economies are only in their early stages of deleveraging and in most countries such deleveraging has been seen first at the household or micro level and later at the national or macro level. [34]Most economies have faced a liquid crunch along with fall in the prices and value of financial assets that has left many unemployed and millions homeless. This has been accompanied by austerity measures that have not been applauded by the people. Hence it would be safe to say that while deleveraging has common stages in the process along with a few unifying factors that are determined by global economic transactions, it is not a uniform process across the world. [35]However most world leader have tried to get together to protect their economic interests yet most countries are far from reviving their economic growth.

The other side of this coin advocates that deleveraging is an economic centric process which is determined merely by the dealing and economic structures of the country while keeping in mind the primary debt reduction. [36]This is what prevents deleveraging from being classified as a universal constant. This is dependent on an array of factors that are exclusive to the specific economy. The state of the banking system and the regulations undertaken by the banking system play a pivotal role in determining the deleveraging. [37]While the weakening of the banking system in failing to recognize heavy but dismal corporate loans had led to a complete fall in major banks and stock markets leading to a sad deleveraging, some banks like in Sweden have nationalized and the government has taken over bad loans to help deleveraging.[38]

The austerity measures adopted by the country also colors the deleveraging process as it is determined by the debt reduction that is allowed after such reforms. While in countries like France and USA many health, education and pension funding’s have been cut back there is still a variance due to the policies undertaken by the government in determining what constitutes an essential service that the state is bound to provide to its citizens. Belt tightening has varied due to the population and its demands along with the fiscal reserve of the individual nation. [39]Another essential factor determining the individual success or failure of a deleveraging is the structural reforms undertaken by the government.

In nations where the structural reform is cemented or evolved to improve foreign investment along with providing a regulatory structure to check the interest and flow of capital deleveraging is made easier as there is a reduction in the national debt. [40]This however is tailored according to the nature of the national economy and its current needs and this cannot be exclaimed as a universal process.  Structural reforms vary long these lines and can range anywhere from reduction is stringent business laws in Spain to regulating business investments is the USA.

Private investment in the economies can also encourage a more holistic deleverage but this is determined by the FDI laws and the nature of the economy. While the private sector is saving rather than investing in the current scenario, [41]it is upon the Government to make laws more attractive while keeping in mind the fiscal reserve so as to attract private investment even if this is small in terms of investment capital. This too is determined according to the taxation and interest rate laws in the country along with the laws governing private – government investment mergers which are different in every economy. [42]

Lastly and most importantly it would be erroneous to say that the current deleveraging is a uniform universal process as it is primarily determined by the national debt and the government surplus. While the GDP is determined to fall in the early stages of deleveraging it is upon the country’s fiscal policies to help support the GDP while repaying debts over a prolonged period. Hence the author advocates that while we must recognize the interwoven economic transactions between global economies it is erroneous to claim that this is a universal and uniform process of remedying the financial crisis.[43]

While the factors discussed above illuminate the individual needs of an economy they are also the factors that determine the success of a deleverage in the national economy.  It is dependent on the time period and the quantity invested in the deleveraging. It is dependent on the debt reduction. Debt reduction as analyzed by the study of the economies discussed is determined by the period in which debt is to be reduced and the method and quantity of debt to be reduced.

The available reserve and the laws influence this process along with the time period, which determines the long term and short-term evolution of the economy. While in the first stage of deleveraging there is a fall in growth and GDP, deleveraging success is consequently determined by the fiscal policies adopted after this stage. [44]Secondly the austerity measures undertaken by the government determine the pace of the deleveraging. However the political and social circumstances must be kept in view while determining such economic policies. The availability of resources for such austerity measures determines the deleveraging in the country and is also dependent on the population of the economy and their subsequent liabilities.[45]

Thirdly debt monetization plays the most crucial role in deleveraging. Debt monetization refers to the printing of currency to encourage liquidity in the fallen markets to promote economic growth while repaying the debt. This monetization must be regulated strictly and controlled in short term phases so as to control the value of the currency and check the inflation in the economy.

Debt monetization is helpful provided it is pre determined and calculated to only ease the economic growth and not to devalue the currency of the economy as this will only further increase the debt.[46] Not often but available is the transfer of wealth from the haves to the have not’s. While this is strong resistance from this method of reducing debt and often it is not the most pragmatic way forward as the wealthy in most nations also from the role of policy makers and put their selfish interests above those of the economy and the masses financial circumstances. Advocating that often increase in luxury taxes and increase in taxation rates over a high income frustrates the potential to promote the limited available investment capital it is resisted and fails to improve the debt of the national economy.[47]

CHAPTER VI- CONCLUSION

Hence while this paper has attempted to bring about the anatomy of a deleverage and its practical implementation in the four countries analyzed it elucidates that for deleveraging to be successful and for the markets to improve the responsibility of reducing debt lies not only on the national government but also on the private sector which is a major stakeholder. Also deleveraging at the household level can help reduce the debt burden in the primary stages. The public sector deleveraging can work only after there is some economic growth that is facilitated by the private sector. This ensures that even in times of indebtedness there is no shut down of economic transactions.

However it is extremely risky to have public and private deleveraging happening at the same time. This is because the risk of the private sector is shifted to the government who has the responsibly to absorb this debt while reducing other public spending. This in turn slows down the GDP and does little to improve the situation. It can lead to a sovereign default as seen in Greece. Hence its should begin with the households followed by the private sector and ultimately transcend to the public sector in order to pull a successful deleveraging. This should then be followed by structural reforms that look to cover the chances and gaping holes in the economic model to prevent massive financial crisis in the future while engineering the policies need to reduce debt over a period of time.


[1] Author – Enakshi Jha , NALSAR University of law – Batch of 2012- 17

[2] Definition- Deleverage, Availabe at: http://www.investopedia.com/terms/d/deleverage.asp, (Last accessed on: October 13, 2013)

[3] Newton, BNY Mellon Asset Management, A Perspective on Risk and Return in a Deleveraging World, Available at:  http://us.bnymellonam.com/core/library/documents/knowledge/Viewpoints/sNewtonPOR.pdf, (Last accessed on: October 12, 2013)

[4] Definition- Leverage, Available at: http://www.investopedia.com/terms/l/leverage.asp (Last accessed on: October 13, 2013)

[5] Indebtedness, Deleveraging Dynamics and Macroeconomic Adjustment, European Union Economic Papers, pp. 38, (April, 2013), Available at , http://ec.europa.eu/economy_finance/publications/economic_paper/2013/pdf/ecp477_en.pdf , (Last accessed on: October 13, 2013)

[6] Adrian Blundell-Wignall, The Subprime Crisis: Size, Deleveraging and Some Policy Options, pp. 11, (2008), Available at http://www.oecd.org/daf/fin/financial-markets/40451721.pdf , (Last accessed on: October 14, 2013)

[7] Paul Krugman, Debt, Deleveraging, and the Liquidity Trap: A FisherMinskyKoo Approach, pp. 25, (February 2011), Available at http://www.frbsf.org/economic-research/files/PKGE_Feb14.pdf, (Last accessed onL October 11, 2013)

[8] Mckisney Global Institute, Debt and Deleveraging : The Global Credit Bubble burst,  (January 2010), Available at http://www.thefiscaltimes.com/sites/default/files/pdf/budget_MGI_debt_and_deleveraging01012010.pdf, (Last accessed on: October 11, 2013)

[9] Mike Whitney, The Meaning of “Austerity Measures” in the Eurozone , (April 24, 2012) Available at http://www.globalresearch.ca/the-meaning-of-austerity-measures-in-the-eurozone, (Last accessed on: October 9, 2013)

[10] Carmen M. Reinhart and Kenneth S. Rogoff , Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten , pp. 20, (December 9, 2012), Available at

http://scholar.harvard.edu/files/brianapendleton/files/financial_and_sovereign_debt.pdf  , (Last accessed on: October 15, 2013)

[11] The Hyperinflation of Chile: Lessons for us all, Economic Policy Journal, (August 29, 2010), Available at: http://www.economicpolicyjournal.com/2010/08/hyperinflation-of-chile-lessons-for-us.html, (Last accessed on: October 13, 2013)

[12] Matthew Whittaker, On borrowed time? Dealing with household debt in an era of stagnant incomes, pp. 14, (December 2012), Available at: http://www.resolutionfoundation.org/media/media/downloads/On_borrowed_time.pdf , (Last accessed on: October 11, 2013)

[13]Ray Dalio, An In-Depth Look at Deleveragings, pp. 2, (February 2012), Available at : http://www.bwater.com/Uploads/FileManager/research/deleveraging/an-in-depth-look-at-deleveragings–ray-dalio-bridgewater.pdf, (Last accessed on: October 15, 2013)

[14] Supra note 5, at pp. 38-39

[15] Supra note 9

[16] Supra note 13, at pp.3

[17]Dealing with debt, The Economist, April 10, 2012, Available at ,  http://www.economist.com/blogs/freeexchange/2012/04/deleveraging, (Last accessed on: October 12, 2013)

[18] Dan Amoss, The Path to $10,000 an Ounce Gold: Revisited, (September 20, 2013), Available at  http://dailyreckoning.com/the-path-to-10000-an-ounce-gold-revisited/, (Last accessed on: October 12, 2013)

[19] Supra note 13, at pp. 3

[20] Morgan Housel, Why it’s so much better than the great depression?, Daily Finance, April 24, 2012, http://www.dailyfinance.com/2012/04/24/why-its-so-much-better-than-the-great-depression/ , (Last accessed on: October 12, 2013)

[21]Masaaki Shirakawa, and Shigenori Shiratsuka, The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and the Lessons, pp. 396,416, (February 2001), Available at ,  http://www.quartetfest.ca/documents/4743/jap_bubble.pdf, (Last accessed on: October 13, 2013)

[22] Gert Wehinger, Bank deleveraging, the move from bank to market-based financing, and SME financing, OECD Journal: Financial Market Trends, pp. 4, (2011), http://www.oecd.org/finance/financial-markets/Bank_deleveraging-Wehinger.pdf, (Last accessed on: October 13, 2013)

[23] Kazuo Ueda, Deleveraging and Monetary Policy: Japan since the 1990s and the United States since 2007, pp. 13, (2011), Available at : http://www.cirje.e.u-tokyo.ac.jp/research/dp/2011/2011cf828.pdf , (Last accessed on: October 13, 2013)

[24] Dean Baker, The Housing Bubble and the Financial Crisis, pp. 73-74, Real World Economic Review, Issue no. 46, (2008), Available at: http://paecon.net/PAEReview/issue46/Baker46.pdf

[25] David Wessel, America’s Grand Leveraging, Available at: http://online.wsj.com/news/articles/SB119690409370315239 , (Last accessed on: October 15, 2013)

[26] Supra note 19, at pp. 7

[27] Ray Dalia, An in-depth look at deleveragings, pp. 5, (February 2012), Available at: http://www.bwater.com/Uploads/FileManager/research/deleveraging/an-in-depth-look-at-deleveragings–ray-dalio-bridgewater.pdf, (Last accessed on: October 11, 2013)

[28] Ibid

[29] Arguments for Deflation, Washington Blog, (September 22, 2009), Available at: http://georgewashington2.blogspot.in/2009/09/best-recent-arguments-for-deflation.html , (Last accessed on: October 11, 2013)

[30]Financial Repression: Developing world deleveraging cycles and their market impact, Balentine,  (February 3, 2013) http://www.balentine.com/2013/02/financial-repression-developing-world-deleveraging-cycles-and-their-market-impact/ , (Last accessed on: October 12, 2013)

[31] Supra note 5, at pp. 18

[32] Supra note 8, at pp. 26-27

[33] Deloitte Survey Report, 2012, Capital Gain, Asset Loss: European Deleveraging, pp. 12, Available at: http://www.deloitte.com/assets/Dcom-UnitedKingdom/Local%20Assets/Documents/Industries/Financial%20Services/uk-ind-fs-bank-survey.pdf, (Last accessed on: October 14, 2013)

[34] Peter de Keyzer, Europe’s Deleveraging and its Political Aftermath, pp. 244, Larcier, (2012)Available at: http://peterdekeyzer.bnpparibasfortis.be/wp-content/uploads/2012/06/BankFinance-2012.pdf, (Last accessed on: October 15, 2013)

[35] Roger Baetigg, Euro Crisis: Default, Austerity and Deleveraging, International Business Times, May 1, 2012, Available at:   http://www.ibtimes.com/eurocrisis-default-austerity-and-deleveraging-693944

[36] David Lipton, Resolving the Crisis and restoring healthy growth: Why deleveraging matters?, (November 12, 2012)Available at: http://www.imf.org/external/np/speeches/2012/111212b.htm , (Last accessed on: October 14, 2013)

[37] Supra note 5, at pp. 6

[38] Carter Doughertey, Stopping the financial crisis: The Sweden Way, New York Times, September 22, 2008, Available at: http://www.nytimes.com/2008/09/23/business/worldbusiness/23krona.html?_r=0 , (Last accessed on: October 13, 2013)

[39] Supra note 8

[40] Global Financing Report, Restoring Confidence and Progressing on Reforms, pp. 92, (October 2012), Available at: http://www.imf.org/external/pubs/ft/gfsr/2012/02/pdf/text.pdf , (Last accessed on: October 10, 2013)

[41] Supra note, at pp. 10

[42] Ibid

[43] Steve Keen, Economics in the age of deleveraging, (February 2012), Available at: http://www.creditwritedowns.com/2012/02/economics-in-the-age-of-deleveraging.html , (Last accessed on: October 13, 2013)

[44] David A. Dodge, Deleveraging: The Bumpy Road Ahead, (September 27, 2012), pp. 4,  Available at: http://www.bennettjones.com/uploadedFiles/News_and_Events/Conferences/Sept%20%2027%20Powerpoint%20%20CFA%20Vancouver.pdf, (Last accessed on: October 14, 2013)

[45] Supra note, at pp. 1

[46] Doug Nolan, The Myth of Deleveraging, Asia Times, October 16, 2012, Available at: http://atimes.com/atimes/Global_Economy/NJ16Dj01.html, (Last accessed on: October 13, 2013)

[47] More on New Zealand’s Deleveraging, February 10, 2011, Available at: http://www.macrobusiness.com.au/2011/02/more-on-new-zealands-deleveraging/, (Last accessed on: October 14, 2013)

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1 thought on “DELEVERAGING – A FARCICAL OR COGNIZANT REALITY?”

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