FRACTIONAL FLOW

Fractional flow, the flow that shapes our future.

NORWAY’s PETROLEUM ECONOMY STRUGGLES WITH DECLINING DEBT PRODUCTIVITY

In this post I present a closer look into the developments in the Norwegian Gross Domestic Product (GDP) and the Marginal Productivity of Debt (MPD) from households, non-Financials and municipalities.

Further a brief update on developments in credit/debt growth (for households, non-Financials and municipalities) in Norway. Sovereign debt and debts in the financial sector are not included in this analysis and for a complete analysis ALL DEBTS have to be included. Norway is a small and open economy that is exposed to developments in the global economy (like the price of oil) and its trade relations.

This post is an expansion to my previous post A closer Look into the Drivers of the Norwegian Economy’s recent Growth Success with some updates.

The post also presents a brief look at how recent years developments in the oil price and total petroleum extraction and sales have affected Norwegian GDP, credit/debt growth, the MPD and petroleum related expenditures and what this may portend for the near future.

NOTE: All financial data in this post are in the Giga Norwegian krone (GNOK; Billion NOK) unless otherwise specified. 6 NOK approximates now around 1 US dollar.

Figure 1: Chart above shows the development in the Norwegian Gross Domestic Product (GDP) split on mainland Norway (brown area) and petroleum and maritime activities (green area). The Norwegian petroleum activities are offshore within the Norwegian maritime economic zone. At present exchange rates Norway’s GDP for 2013 was around $500 Billion (nominal). The black line shows the development for total nominal disposable income for Norwegian households.

Figure 1: Chart above shows the development in the Norwegian Gross Domestic Product (GDP) split on mainland Norway (brown area) and petroleum and maritime activities (green area). The Norwegian petroleum activities are offshore within the Norwegian maritime economic zone. At present exchange rates Norway’s GDP for 2013 was around $500 Billion (nominal).
The black line shows the development for total nominal disposable income for Norwegian households.

The chart illustrates how the Norwegian GDP has been on a steady growth trajectory during the recent four decades and how petroleum activities, which started in the late 1960’s,  gained in relative importance of GDP developments. The effects of growth in the petroleum activities are documented to spill over into the mainland GDP.
In 2013 around 23% of Norway’s GDP was from petroleum related activities.

The acceleration in the Norwegian GDP from around 2004 have been identified to come from two main sources;

  1. The growth in the oil price that really took off from around 2004 spilled over to the mainland economy.
  2. The credit/debt growth from households, non-Financials and municipalities.
    This was likely triggered by the growth in the oil price as it revived consumers’ perception of improved outlooks to service more debt as disposable income grew and interest rates started to decline (cheap credit), which again was reinforced from the feedback from rising housing prices and growth in stock indices (equity growth).

As Norwegian petroleum extraction is in general decline and its gross revenues subject to oil price developments, the remaining force to sustain Norwegian GDP growth is to entice the households for continued growth in debt financed consumption.

THE OIL PRICE AND NORWAY’s GROWTH IN SPENDING FOR PETROLEUM RELATED ACTIVITIES

Figure 2: The chart above shows the development in actual spending for petroleum related activities (by discipline) for the years 2001- 2013 and Norwegian Petroleum Directorate’s (NPD) forecast for the years 2014 - 2018 [stacked columns and right hand scale]. The developments in the annual nominal oil price (Brent spot) are shown as yellow circles connected by a black line [left hand scale].

Figure 2: The chart above shows the development in actual spending for petroleum related activities (by discipline) for the years 2001- 2013 and Norwegian Petroleum Directorate’s (NPD) forecast for the years 2014 – 2018 [stacked columns and right hand scale].
The developments in the annual nominal oil price (Brent spot) are shown as yellow circles connected by a black line [left hand scale].

The recent years high spending levels of petroleum related activities offshore Norway were closely linked to the growth in the oil price. Within the oil companies’ discovery portfolios there were discoveries that became commercial with the high oil price.

In 2013 total spending on petroleum related activities were around 9% of Norway’s GDP.
Access to debt and lowered interest rates even caused some oil companies to take on developments (overvaluing recoverable reserves) that turned out to be unprofitable and subsequently led to write downs. This became capital destruction and has impaired the oil companies’ abilities for future spending (investments).

Statistics Norway in a recent update expects a considerable decline in spending on petroleum related activities in 2015. Developments that have been sanctioned are likely not to be affected, but the oil companies debt overhang and cash flow developments impair future developments and thus spending levels.

HOW MONEY IS CREATED FROM BANK CREDIT

To understand how the growth in credit/debt is facilitated, it is paramount to understand the process used by the banks to create debt (and thus money).

The reality of how money is created today differs from the description found in some economics textbooks:

  • Rather than banks receiving deposits when households save and then lending them out,
       bank lending creates deposits.
  • In normal times, the central bank does not fix the amount  of money in circulation, nor is
    central  bank money ‘multiplied up’ into more loans and deposits.

From:“Money creation in the modern economy

Bank of England Quarterly Bulletin 2014 Q1

Got that?

If not, reread the above and think deeply about it, until you get it!

Bank lending is NOT a neutral activity by which some savers defer their consumption (saves) so that the bank can lend those savings at interest (profit) to someone credit worthy (who wants to borrow to finance any enterprise [starting a business or buying a house, car, cabin, boat, vacation etc.]) and who exhibits a good probability of making good on the promises made.

In modern banking the bank simply creates the credit/debt “ex nihilo” and the (signed) promissory note from the borrower becomes an asset for the bank. Most loans are simply accounting entries.
(There are requirements for the bank with regard to enforcing reserve requirements [Ref Basel III]).

Former Fed president Marriner Eccles (who was honored by having the Eccles building in Washington named after him) told the US Senate in the late 1930s:

  • “If there were no debt in our money system, there would be no money.”

THE MARGINAL PRODUCTIVITY OF DEBT IN NORWAY

The Marginal Productivity of Debt (MPD) by vintage, has been estimated as shown by the formulae below:

Marginal Productivity of Debt (MPD) = (Change in nominal GDP) / (Change in nominal Debt)

The MPD relates to the change in the level of all debt (consumer, corporate, sovereign, financial) in a country to the change in its GDP in a specified year.
The MPD metric serves as an indication on how effectively the economy (estimated as GDP) transforms additional debt.

An MPD above 1 indicates that the debt is having a healthy, productive effect on the GDP.

An MPD below 1 towards 0 indicates declining productivity of additional debt to GDP (some argue this is transmuting wealth into income).

A negative MPD indicates that additional debts do not result in growth in GDP. (This movie is and has been playing at theaters in some countries.)

Figure 3: Chart above shows Year over Year (YoY) change in Norwegian nominal GDP (inclusive petroleum related activities) [blue columns, rh scale] and YoY change in nominal total debts (households, municipalities and non-Financials (inclusive oil companies and companies delivering products/services to the petroleum industry) [red columns, rh scale]. The thick black line shows the Marginal Productivity of Debt (MDP)  by vintage and the thin gray line the 5 year trailing average plotted against the lh scale. In 2013 1.00 NOK of additional debt added less than 0.40 NOK to the GDP.

Figure 3: Chart above shows Year over Year (YoY) change in Norwegian nominal GDP (inclusive petroleum related activities) [blue columns, rh scale] and YoY change in nominal total debts (households, municipalities and non-Financials (inclusive oil companies and companies delivering products/services to the petroleum industry) [red columns, rh scale].
The thick black line shows the Marginal Productivity of Debt (MDP) by vintage and the thin gray line the 5 year trailing average plotted against the lh scale.
In 2013 1.00 NOK of additional debt added less than 0.40 NOK to the GDP.

The chart above illustrates how vulnerable the Norwegian economy (as expressed by GDP) in recent years has been and is to changes in the oil price. The effects to the MPD is not contained to the effects of the oil price (the parameter everyone keeps their eyes on), but is compounded by the effects of the changes in volumes of petroleum extracted and sold.

As Norwegian petroleum extraction is in general decline, the sensitivity on MPD from movements in the oil price will diminish.

  • Higher MPD in 2000 was due to a higher oil price and a very strong US dollar (all data are in the Norwegian currency krone, NOK).
    Norwegian crude oil extraction peaked back in 2000/2001.
  • As the oil price started to climb in 2004 towards its apex in 2008, MPD entered a general decline.
    This runs contrary to what should be expected (exception being the reversal of the decline from 2007 to 2008 due to the YoY relative strong increase in the oil price) if the dominant influence on GDP came from the oil price.
    Reasons for this are more likely due to the decline in crude oil extraction which was partly offset from increased natural gas sales and (more likely and predominantly) the growth in total credit/debt, of which a big portion was used to fund household consumption growth (refer also to figures 4 and 8).
  • In 2009 MPD was a negative of 1.8 NOK for each NOK of debt added. The main reason for this was the collapse of the oil price in late 2008 which YoY declined by 40% from 2008 to 2009.
  • The continued growth in the oil price from 2010 to 2011 improved the MPD and debt growth resumed (refer also to figure 8 that shows changes in the 12 months totals in debt by sector).
  • Since 2011 the MPD has been in decline and data for Q1 2014 from Statistics Norway shows that this decline continues. It is now believed there are 2 main contributors to this;
    A) The continued decline in Norwegian petroleum extraction and effects of several unprofitable investments for developments of petroleum discoveries.
    B) Lower growth in disposable income. The marginal productivity of additional debt (MPD) declines with the need to service the growth in total debts (refer also to figure 7).
    The drive to reduce interest rates may improve the potential for and entice borrowers to take on more debt (grow their balance sheets) in a bid to continue growth in Norway’s GDP. GDP growth is highly correlated with debt growth.
  • A (much) higher oil price will improve the MPD.

One interpretation of the declining MPD in Norway is that meaningful increases in productivity have been substituted by debt expansion for consumption.

NOTE: The chart above does not adjust for the effects from the infusions from the so-called spending rule for public spending from the Government Pension Fund Global (GPFG; The Norwegian sovereign wealth fund).
In 2013 this spending constituted around 120 GNOK. The estimates do not include changes in sovereign and financial debts.

THE GOVERNMENT PENSION FUND GLOBAL (GPFG)

 “The fund is an integrated part of the government’s annual budget. Its capital inflow consists of all government petroleum revenue, net financial transactions related to petroleum activities, net of what is spent to balance the state’s non-oil budget deficit.

This means the fund is fully integrated with the state budget and that net allocations to the fund reflect the total budget surplus, including petroleum revenue. Fiscal policy is based on the guideline that over time the structural, non-oil budget deficit shall correspond to the real return on the fund, estimated at 4 percent. The so-called spending rule, stating that no more than 4 percent of the fund over time should be spent on the annual national budget, was first established in 2001.”

A real return of 4% assumes over time an average nominal return of 7%, which will prove challenging to achieve given the present interest policies from the leading central banks (Fed, ECB, BoE, BoJ), general developments in companies’ earnings (stock prices and dividends) and the effects from a growing total global debt overhang.

ARE NORWEGIAN HOUSEHOLDS TRANSMUTING DEBT INTO INCOME?

In this section I take a closer look into how effectively the YoY increase in Norwegian household debts affects their YoY changes in disposable income.

The metric that is used is Household Income Productivity of Debt (HIPD),  which formulae is shown below:

Household Income Productivity of Debt (HIPD) = (Change in Household Disposable Income) / (Change in Household nominal Debt)

The logic for the HIPD metric follows much the same principles as described for MPD earlier.

Figure 4: The chart above shows Norwegian households YoY change in disposable income [blue columns, rh scale] and households YoY change in debt [red columns, rh scale]. The thick violet line shows the YoY change in HIPD by vintage and the thinner violet line the 5 year trailing averages of HIPD [both lh scale].

Figure 4: The chart above shows Norwegian households YoY change in disposable income [blue columns, rh scale] and households YoY change in debt [red columns, rh scale]. The thick violet line shows the YoY change in HIPD by vintage and the thinner violet line the 5 year trailing averages of HIPD [both lh scale].

The developments in the HIPD (shown in the chart above) suggest that Norwegian households are and have been transmuting wealth into income. In a housing market that for any casual observer demonstrates growth in the market value of its housing stock, the interpretation above may seem out of touch with the real world.

A house is worth whatever the bank is willing to lend against it. As long there is credit/debt growth and borrowers show the prospects of servicing their debts, house prices will be priced according to what buyers can pay.

Several external studies and observers have found that there is a Norwegian housing bubble. When this housing bubble bursts, the transmutation of wealth to income will become a fait accompli.

Growth in Norwegian household debt has mostly found its way for conspicuous consumption, even though most households perceive these as investments.

As long there is growth in credit/debt, it creates the illusion of “free money/wealth”. However profit taking requires the objects subject to increase in its market value to be liquidated. A slow down/reversal of credit/debt growth will reveal this price growth for what it really was; virtual.

One careful observation of the growth in household disposable income is that (household) debt growth may have allowed for wage growth and thus growth in disposable income. Several (amongst OECD) have estimated that wages in Norway are around 40% above the level of its natural competitors.

RELATIVE CHANGES IN NORWAY’s GDP, MAINLAND GDP AND DEBTs PORTION OF GDP

Figure 5: The chart above shows relative developments for Norwegian YoY change in GDP [black lines] and Norwegian mainland YoY change in GDP [green lines] and households, non-Financials and municipalities (munis) YoY change in debt relative to GDP [red lines]. Thicker lines show the 5 year trailing averages.

Figure 5: The chart above shows relative developments for Norwegian YoY change in GDP [black lines] and Norwegian mainland YoY change in GDP [green lines] and households, non-Financials and municipalities (munis) YoY change in debt relative to GDP [red lines].
Thicker lines show the 5 year trailing averages.

The chart shows that since the mid 1990’s Norway’s GDP has been very much  aligned with growth in total debt. The swings in the oil price has caused superimposed up and down turns in Norway’s GDP. It is worth noticing that the growth in debt (relative to GDP) has been stronger than the GDP growth during the better part of the recent two decades.

  • During the 1990’s Norway’ crude oil extraction and sales grew strongly as the nominal oil price remained in the $15 – $20/bbl  range. Growth in oil extraction appears to have been a strong driver for Norwegian GDP developments during the 1990’s.
  • In the early 2000’s a strong dollar (weakened krone) and higher oil price boosted GDP. This GDP growth was enhanced by the strong growth in debt (refer also figure 7).
    A weaker oil price in 2002 slowed GDP growth, which was sustained by growth in debt.
  • Since 2004 GDP growth was accelerated by the strong growth in the oil price (refer also to figure 1) reinforced by a strong acceleration in debt growth (refer also to figure 7).
    (The Norwegian economy became addicted to debt steroids.)
    The compounded effects with growth in the oil price and debt raised annual GDP growth to just below 10% in 2008. The total growth in debt for households, non-Financials and municipalities were around 14% of GDP in 2008.
  • In 2009 the Norwegian GDP contracted driven by a lower oil price and slower debt growth.
    Since 2009 mainland GDP (which is exclusive of petroleum activities) had a stronger growth than Norway’s GDP, suggesting strong influence from debt growth and spill over effects from the high level of investment activities in petroleum related activities (refer also figure 2).
  • As the oil price gradually gained renewed support during 2010 and 2011, the debt growth resumed (refer also figure 8)
  • Since 2011 the oil price has softened, petroleum extraction has been in a general decline and modest growth in debt conspired to a steep decline in GDP growth.

A decline in the oil price and thus total petroleum revenues can (only) in the short term be offset by growth in debt to curtail any decline in GDP.

Figure 6: Chart above shows YoY change in mainland Norway GDP [green lines) and total changes to households, non-Financials and municipalities debt relative to mainland Norway GDP [red lines].

Figure 6: Chart above shows YoY change in mainland Norway GDP [green lines) and total changes to households, non-Financials and municipalities debt relative to mainland Norway GDP [red lines].

For the period 1996 – 2013 the correlation between changes in mainland GDP and debt was above 0.7.

A big portion of the debt growth in non-Financials is likely from oil companies and petroleum related industries/services assuming more debt to manage an increased demand created by the high oil price, spurring increased spending on petroleum related activities, refer also to figure 2 and 8. The increased activities from petroleum related developments has a considerable spill over effect on mainland Norway GDP.

The chart above illustrates that debt growth was the primary driver for growth in mainland Norway GDP and also that the marginal productivity from this debt has been worrisome low.

DEVELOPMENT IN DEBTS FOR NORWEGIAN HOUSHOLDS, MUNICIPALITIES AND NON-FINANCIALS

One of the strongest and less recognized drivers of the Norwegian economy is the exceptional credit/debt growth from primarily households and municipalities. Debt growth for non-Financials (like corporations) very much follows business cycles which in Norway are well aligned with the level of petroleum related investments (refer also figure 2).

Figure 7: The stacked areas in the chart above show development in total debt (municipalities [grey area], non-Financial [orange area] and households [blue area] plotted against the rh scale). The black line, plotted against the lh scale show year over year relative change in total debt for these sectors.

Figure 7: The stacked areas in the chart above show development in total debt (municipalities [grey area], non-Financial [orange area] and households [blue area] plotted against the rh scale). The black line, plotted against the lh scale show year over year relative change in total debt for these sectors.

Total debt for Norwegians’ households, municipalities and non-Financials doubled over the last 8 years (from 2005 to 2013), that is a compounded annual growth rate (CAGR) of around 9%.

Norway’s GDP grew at a CAGR of 5.5% in the same period (2005 – 2013) when oil prices were high.

The growth in debts was from a higher base than the GDP in this period.

The burden of servicing the growing total debts will continue to lower the marginal productivity of debt.

At the end of 2013 the ratio of Norwegian household debt to disposable income was around 200%, which is one of the highest in the world. In the USA the same ratio was around 130% when the housing bubble burst.

Figure 8: Chart above shows Norwegian households’ [blue columns], non financial [orange columns] and municipalities [grey columns] 12 Months Moving Totals (annualized) change in debt plotted against the rh scale. The green dots connected by black lines show the development in the nominal oil price (Brent spot) plotted against the lh scale.

Figure 8: Chart above shows Norwegian households’ [blue columns], non financial [orange columns] and municipalities [grey columns] 12 Months Moving Totals (annualized) change in debt plotted against the rh scale. The green dots connected by black lines show the development in the nominal oil price (Brent spot) plotted against the lh scale.

For the period 1996 – 2009 the correlation between changes in debt and the oil price was 0.84. Since 2011 this correlation has been negative. This may suggest that the continued debt growth is now driven by its own momentum.

By assuming and growing their total amounts of debts over the recent 15 years, it allowed Norwegians to live well beyond their means.

Debt is used (assumed) to bring future sales into the present because of a lack of wealth.

As debts are primarily used for consumption this grows public revenues and it is estimated that around half of the consumption driven debt growth ends up as income for the public to fund their budgets.

During the recent months the debt growth from non – Financials has declined (which may reflect lowered expectations for petroleum related spending), while households and municipalities maintain their nominal additions to total debt.

Households continued growth in debt for consumption is now believed to cause further declines in the income productivity of debt (HIPD).

In a situation where the sectors described do not have the capacities (no room left on their balance sheets) to take on further debts, this will affect the level of public income and thus lead to fiscal belt-tightening.

The growth in debt (created “ex nihilo”) sustains demand, support prices (also for housing) and fuels the growth in market values. On paper this appears as wealth growth for consumers. This is, however, considerable virtual wealth as the households to their dismay will discover when debt growth slows and even may enter a period of deleveraging.

In the recent year non-Financials (businesses and corporations) has slowed down their debt assumptions, while households and municipalities sustains total nominal debt growth.

As total debt grows, the growing costs of its service gradually erodes the potential for both production and consumption. The growth in total debts will gradually slow down the output potential for the economy. This should explain the marginal productivity of debt (MPD). This is very much aligned with the law of diminishing returns.

Lending (using credit/debt also as leverage) makes sense if one borrows at x%, which yields y% as long y is greater than x.

More credit/debt bids up prices (like in the housing market) and at some point an increasing number of bidders are left out and housing prices start to decline. This mechanism feeds on itself as a growing number of bidders starts to hesitate and decides to wait on the sidelines in expectation of prices to come further down.

The easy lending sends asset prices rising beyond all practical affordability (housing) as it becomes a bidding war simply because of easy credit, not because of intrinsic value.

WHAT THE FUTURE MAY HOLD FOR THE NORWEGIAN ECONOMY

As is well known; predictions are difficult, especially about the future.

However, what is presently known gives away some suggestions for developments come Norway’s way:

  • Norwegian petroleum extraction will continue to be in a general decline.
    In Norwegian Crude Oil Reserves and production per 2013 I showed developments in actual Norwegian crude oil production and my forecast towards 2040 based upon what can be whipped out of confessions from NPD’s data.
    Norwegian natural gas extraction and sales, which is at a plateau, is expected to enter a steep decline at the end of this decade.
  • The oil price is likely to soften barring any major geopolitical events. I presented my reasoning in the post Central Banks’ Balance Sheets, Interest Rates and the Oil Price.
  • The NPD’s forecast for the (high) investment levels for petroleum extraction offshore Norway is expected to decline towards the end of this decade, if not earlier. In recent years the investment levels have shown good correlation with the oil price and the oil companies’ portfolios held discoveries that met the commercialization hurdle for developments requiring a high oil price.
    Recently the oil companies have struggled with declining returns and resorted to growing debt and asset sales  to meet their expenditure commitments and pay dividends. The reality from inadequate cash flows have made them implement fierce programs to reduce operational expenses and lower the commercial break even price for future developments and thus lower capital expenditures (investments).
  • Households and municipalities may still have capacities left on their balance sheets and willingness to take on more debt, but there are now ample reasons to expect that additional debts will have diminishing effects on the Norwegian GDP.
  • The market value of the Government Pension Fund Global (GPFG) may any time become subject to downdrafts from turbulence in the global financial’s. Changes to the GPFG may affect the amount that may be spent from the so-called spending rule which states that over time no more than 4 percent of the fund may be used for public spending (this rule was established under the assumption that over time the annual average return for the fund would be 7%).
  • It has been noted with amazements that the number crunchers at Statistics Norway (as well as in Norway’s major banks) appears not to include the effects of debt growth in their models projecting future trajectories for Norwegian GDP (this movie was recently played at theaters in other countries).
    The financial/monetary mechanisms governing the Norwegian economy are no different from those in other countries.
    This should call for some eyebrows to be raised as there is ample evidence that debt growth in recent years was a considerable contributor to growth in Norwegian GDP.
  • How much longer the major central banks (Fed, BoJ, ECB, BoE) yield curve shaping [long bond price fixing {some refers to it as interest suppression}] and balance sheet expansions can be continued is anybody’s guess. Even small upward movements in the interest rate will, due to the growth in global total debt levels, have considerable effects.
    The influence the Norwegian central bank may have on domestic interest rates (which are subject to global developments) should be considered in this context.
  • Norway has its own sovereign currency (the Norwegian krone [NOK]) and oil is priced in US$ and the US$ is the world’s dominant reserve currency.
    The Norwegian krone [NOK] is (like most other currencies) very much joined to the US$ at the hip.

These are some of the important ingredients that could conspire to form what may become “The Perfect Storm” for the Norwegian economy.

There is no reason to believe that Norway’s growth in GDP of growing total credit/debt is sustainable, and if continued, is likely to further the decline in the marginal productivity of debt (MPD) and a more violent correction in the economy when it occurs.

This is where it becomes appropriate to remind about the so-called Minsky Moment.

“Ultimately the debt burdens created during periods of market euphoria cannot be met by the cash flows of the stuff that the borrowers bought (for conspicuous consumption) with their debt, which causes the banks and (shadow banks) to withdraw credit in a spasm of sudden fear. Because there’s no more credit to be had for more buying and everyone is levered to the hilt anyway, stuff either has to be sold at fire-sale prices or debts must be defaulted, either of which just makes the banks withdraw credit even more fiercely.
The Minsky Moment is this spasm of private credit contraction and the forced sale of even non-speculative assets into the abyss of a falling market.”

BBC NEWS MAGAZINE has an excellent analysis and resources in “Did Hyman Minsky find the secret behind financial crashes?”

What has been shown in this post is that the recent years credit growth has been a considerable contributor to Norwegian GDP growth. As petroleum revenues and investments are expected to decline, continued growth in Norwegian GDP becomes increasingly dependent on the continued debt growth of highly levered households and municipalities.

Which is exactly what some researchers at Statistics Norway (not referring the balance sheet issue) expects shall further Norwegian GDP growth.
When will the households, non-Financials and municipalities balance sheets be used up? (That is, reach peak debt.)

Future developments in total debt levels appear to become the twilight zone for future Norwegian GDP developments.

“On a long enough time line, the survival rate for everyone drops to zero.”

– Chuck Palahniuk, “Fight Club”

Morpheus:“Unfortunately, no one can be told what The Matrix is. You have to see it for yourself.”

From the movie “THE MATRIX”

 

 

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