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Currencies
To Gisele and Jay-Z: US ‘Twin Deficits’ Are Shrinking November 16, 2007 By Stephen Jen | London Summary and conclusions[1] Investors are too bearish on the dollar. While there are ample cyclical reasons to remain cautious about the dollar, we believe that the dollar’s sell-off against the EUR and GBP is far overdone. We wait patiently for a healthy USD rebound in 2008. One of the key reasons behind our thinking, besides valuation and our view that the The There has been a dramatic deterioration in the US C/A deficit since 1991 — from a small surplus (due to the war reparations from This improvement in the C/A balance is particularly stark when we consider that oil prices have risen so much in recent quarters. Since oil and petroleum product trade accounts for about 38% of the total trade deficit of the Further, there is the ‘J-Curve’ effect. This is the dynamic effect whereby currency depreciation initially raises the import bill, through the price effect, before the underlying trade volumes adjust to respond to the weaker currency. Our back-of-the-envelope calculations suggest that the ‘J-Curve’ effect could trim up to another 0.5% of GDP from the published trade deficits — implying that the C/A deficit could already be close to 4.5% of GDP, adjusting for the J-Curve effect, further underscoring the strength of the improvement in the US C/A position.[2] We believe that this trend improvement in the US C/A deficit is structural and not temporary, due to the turn in the The Federal fiscal deficit is also shrinking fast Contrary to the widely held view in the past three years that the Bush Administration’s promise of compressing the fiscal deficit would not be met, the US Federal fiscal balance has shrunk faster than projected by the US Treasury or the OMB. The OMB forecasts that the fiscal balance will be in surplus by 2011, for the first time since 2001.[3] While there are clear demographic challenges, our point is that the powerful revenue-centred improvement in the fiscal balance in the US is perhaps not as well celebrated by investors as it should have been, given that econometric tests support the popular impression that the US fiscal position has historically been a driver of the fair value of the dollar. The ‘twin deficits’ are shrinking fast Although we are well aware that it is theoretically incorrect to add up the twin deficits, we have done so to point out that investors’ prejudices against the dollar should eventually catch up to the improvement in the underlying trend. Between 2000 and 2004, the combined twin deficits deteriorated sharply, which formed the root of much of the structural bearishness on the dollar and calls for its imminent collapse. Not only has the dollar not crashed, but the twin deficits are also expected to shrink down to less than 4% of GDP in the next two or three years — a level that would make even Gisele and Jay-Z proud. A positive perspective on the current state of affairs Despite the intense angst among investors about the current situation in the financial markets and the Bottom line The US’ ‘twin deficits’ are shrinking fast, and in the next two to three years are likely to slim down to a level that would make even Gisele and Jay-Z proud. Adjusting for the ‘J-Curve’ effect and the high oil prices, the improvement in the underlying trade balance in the -------------------------------------------------------------------------------- [1]Supermodel Gisele Bündchen was reported to have insisted on writing contracts in euros rather than dollars, and rapper Jay-Z appeared in a video showing a wad of €500 bills rather than the traditional US$100 bills. [2]We should note that, while a weak dollar has a J-Curve effect that temporarily exaggerates the [3]We note, however, that the OMB’s fiscal balance forecast is based on rather dated growth forecasts, which are likely to be revised down. This fiscal forecast is also, of course, predicated on whether or not the
Japan
Darkest Before the Dawn? (Part 1) November 16, 2007 By Takehiro Sato | Tokyo, Takeshi Yamaguchi | Tokyo Playing it safe, in recognition of some downside risks Certainly, most Japanese financial institutions have not been directly affected by sub-prime mortgage-related problems, but the liquidity crunch in overseas markets since the summer could turn into a true credit crunch if policymakers do not respond appropriately. In this case, In light of the risks, we lower our growth forecast for The impact of a This past summer, when the sub-prime mortgage-related shocks hit, the If the US economy weakens, however, Japan’s economy is likely to hold up fairly well, considering that the growing presence of emerging economies has contributed to a decline in the US’s contribution to global growth from an average of 20% in the late 1980s to 2000 to an average of 10% since 2001, and the US’s proportion of Japan’s real exports has declined from about 30% in the tech bubble years (1999-2000) to an average of less than 10% since 2002. Our colleagues covering emerging markets expect all regions to do well in 2008, and consequently we expect One concern we have is that it is unclear what proportion of Outlook for The economy slowed in the summer, as we expected, but by a greater magnitude because of the financial market turmoil stemming from sub-prime mortgage-related problems. The economy started to grow again in Jul-Sep, as strong overseas demand, mainly in Housing investment on a GDP basis is unlikely to recover until Apr-Jun 2008, because housing starts will probably level off for the rest of 2007. We expect housing investment to have a 0.3pp negative impact on growth in F3/08 but a positive impact of the same extent in F3/09. The swing in housing investment is of a larger magnitude than we expected, but even with all the uncertainties for the global economic outlook, we do not think Japan’s headline GDP growth in 2008 will be all that weak, thanks to a rebound in housing investment. With manufacturers planning to increase output of digital consumer electronics in anticipation of a peak in demand before the Beijing Olympic Games, industrial production is likely to remain solid in the first half of 2008. The resulting strength of income formation in the corporate sector, particularly large manufacturers, should spill over to the household sector, albeit partially. We think consumer spending will pull out of a summer slump and recover moderately from Oct-Dec, in light of growth in employment and a moderate increase in employees’ compensation. A pullback in IT-related manufacturing is still very much a concern, but looking at micro trends also, we do not think there is as much of an inventory glut as the macro data show. So Risks One potential downside risk for the above scenario is the recent growing pullback of liquidity in overseas markets developing into a genuine credit contraction and hurting momentum in overseas economies. While companies are drawing on commitment lines from banks to deal with liquidity pullback, this situation implies potentially higher credit costs at banks. Increased credit costs from liquidity-related bankruptcies undermine the financial intermediation function and could turn into an all-out credit crunch. We think too much emphasis on moral-hazard risk by overseas authorities as they address the credit contraction might delay crisis action, as happened in the late 1990s in Another downside risk is the residential investment problem. This is a policy issue affecting supply and not a demand concern, as mentioned previously. However, it could affect related segments, including funding difficulties for construction firms, delayed mortgage loan initiatives, and weaker housing-related consumption, if the current sudden brake on housing starts is prolonged. We also expect an impact on capex from the recent sharp decline in factory, warehouse, office, and other non-residential starts in addition to housing starts. In fact, the downturn in construction goods shipments has accelerated since September. Yet we predict upside for the F3/09 growth rate on a rebound from this setback in domestic demand if starts stage a relatively upbeat recovery from the beginning of 2008, in line with our outlook. Hence, the F3/09 growth rate may not drop much, even with slower momentum from overseas economies. The upside risk comes from a new phase of euphoria in asset markets if bold monetary easing and liquidity supply by monetary authorities in response to the liquidity pullback successfully halt the crisis. Liquidity assistance from authorities has created asset bubbles after previous events, which tend to occur once a decade such as Black Monday in 1987 and the Asian and Russian crises in 1997-98. Although some observers may think it is too early to talk about the possibility of a renewed bubble right after the collapse of a credit bubble, we think it deserves consideration, given the past track record. Emerging countries are sustaining robust performance despite downside risk for major economies, and hefty increases in energy and primary commodity prices are generating bubble-like conditions. Although we question the economic rationale of US$100/barrel oil prices, capital from emerging economies with a high risk tolerance is naturally flowing into markets with attractive anticipated returns to generate income, given sluggish performance by the asset markets of major countries.
United States
Scant Evidence of Import-Price Pass-through -- So Far November 16, 2007 By Richard Berner | New York Is a weaker dollar inflationary? The answer, obviously, is yes. It’s clear that a weaker dollar will, other things equal, boost import prices and possibly inflation expectations, and thus inflation. But other things aren’t equal: I think that the economy is weakening, pricing power is fading, and thus, in today’s circumstances, the dollar’s influence on inflation likely will be small. That logic also applies to the influence of rising commodity prices on inflation. Thus, notwithstanding the Fed’s legitimate concerns about inflation risks, officials will have some latitude to respond to the incipient and palpable weakening in economic activity. A number of clients listen politely to my rendition of that story, but quite reasonably disagree. Their logic: The dollar’s decline is contributing to the surge in dollar-based commodity prices like oil and food, which boosted headline inflation to 3.5% in the year ended in October — and will push it past 4% in November. That rise might yet hike inflation expectations, and import prices are accelerating. Sellers may pass a portion of such price hikes through to consumers. And even if that pass-through process is muted and slow, the Fed’s concern about future inflation risks and their apparent new focus on headline as well as core inflation means that there are high hurdles to further monetary ease. Who is right? By any metric, What’s more, there is no doubt that a weaker dollar has boosted import and some domestic prices. The dollar on a broad, trade-weighted basis has depreciated by 8.3% over the past year. And I believe that a weaker dollar has been a factor contributing to higher oil prices. That’s because the decline in the dollar is reducing the non-dollar value of oil producers’ receipts, and thus of their purchasing power. Eric Chaney and I think oil producers are trying to offset that purchasing power lost to a weaker dollar by restraining crude supply, thus keeping prices high (see “The Oil-Dollar Link,” Global Economic Forum, July 23, 2007). We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4 month lag, via transport fares, some rents, and other goods and services. In addition, prices of imported foods jumped by 9.8% and those for consumer goods excluding autos rose by 1.4% in the year ended in October. Those quotes don’t yet reflect the full extent of the recent dollar weakness, so there is more on the way. Finally, my colleague Qing Wang is concerned that China — long viewed as a source of global disinflation — is now facing the risk of runaway inflation (see “Risk of Out-of-Control Inflation on the Rise,” China Economics, November 14, 2007). Some argue that the fact that Unlike in the spring, however, when inflation expectations were higher, the economy was stronger, and there was less slack in the economy, I think that these import price hikes are less likely to translate into higher inflation today. The key reason is that the slipping dollar isn’t the whole story. That’s because the boost to inflation from a weaker dollar has dwindled over the past two decades, reflecting weakening links between exchange rate changes and import prices and ultimately consumer prices. Several Fed economists in a paper last year found that the decline is a global phenomenon. Across G7 currencies, their work suggests that exchange rate pass-though to import prices has declined to 40% over the past 15 years from 70% in the 1970s and 1980s, and in the US, it has declined to only 30% (see Jane Ihrig et al., “Exchange-Rate Pass-through in the G7 Countries,” International Finance Discussion Paper 851, January 2006). That is, a 10% sustained depreciation in the dollar might, other things equal, boost the import price level by 3% over a 2-3 year time period. The empirical fact that such exchange-rate “pass-through” has apparently weakened over the past several years, like the flattening in the Phillips curve, may reflect good monetary policies. As well, it probably results from the globalization of markets and production that has promoted “pricing to market.” That is, exporters not wanting to surrender market share have more closely matched their prices to those in their destination market and set their prices in the local currency; they tend to hedge their currency risk either ‘naturally’ by sourcing abroad or financially. That probably muted the pass-through and lengthened the lags from currency moves to changes in relative prices long before the dollar began its descent. This pass-through link also varies with the cyclical state of the global economy and inflation expectations. Over the past year, the weaker dollar may explain half the increase in the recent increase in import prices. And the booming global economy may have accounted for the other half, by increasing the pricing power of exporters to the
Source: US Bureau of Labor Statistics
Global factors — higher energy, non-oil commodity and import quotes, and a weaker currency — might also contribute to US inflation by reviving inflation expectations. So far, however, the signals are mixed: Inflation compensation measured by 10-year TIPs spreads has risen by about 20 bp from its August lows, to 235 bp. But distant-forward breakevens declined to four-month lows in recent days, hinting that these developments haven’t much altered market participants’ underlying inflation expectations. Survey-based inflation expectations, such as the measure of 5-10 year expectations compiled by the The most important factor affecting inflation expectations is back home: The Fed. Clear objectives and a straightforward sense of how to get there are both critical to anchoring longer-term inflation expectations. And by and large, the Fed has been successful in doing exactly that over the past several years. The FOMC’s just-announced changes to the way they communicate with the public — updating forecasts four times a year instead of two, projecting headline and core inflation, and extending the forecast horizon from two years to three — should help market participants understand how the Fed views the inflation outlook. Gone is the old pretense of a 1% to 2% “comfort zone” for core PCE inflation, and in its place will be specific, third-year forecasts for both headline and core inflation. I’ve long argued that both matter and that they matter for the Fed (see “Which Matters More: Headline or “Core” Inflation?” Global Economic Forum, October 2, 2006). Investors will quickly conclude that these ‘forecasts’ represent the Fed’s preferred outcomes. My hunch is that they will both center on 2%, which builds in a cushion for measurement error and disinflationary shocks. Such clarity should help the Fed convince investors of the logic behind its views. However, the Fed does have a communication problem: Fed officials have clearly stated their concerns about inflation risks and seem to have a high hurdle for further ease. But their concerns about inflation ring hollow to many market participants, because they think the Fed’s balanced statement after the October 31 FOMC meeting was out of step with reality. Financial turmoil is promoting a flight to quality as well as a near-certain view that inflation is not a problem, and that the Fed will ease in December and beyond. Having watched the Fed go along with the market’s program in October, investors believe that the Fed will validate market expectations again with another move in December and more to come after that. This disconnect won’t likely go away soon. How to play that contrast in views? The yield curve will continue to steepen in almost any scenario. If inflation stays low, additional Fed ease will reduce short-term rates more than longer-term yields. On the other hand, with a set of global factors potentially pushing up inflation expectations, lingering questions about the economic outlook may translate into market uncertainty that pushes up term premiums and steepens the yield curve. In our view, investors should buy TIPS as attractive insurance. Risks abound, because the inflation outlook is uncertain. The inflation tug of war might tip in the opposite direction if the dollar’s slide gathers steam. A rebound in inflation likely would further undermine today’s fragile financial-markets. The threat of protectionism could add to inflation risks, because it would block competition from overseas goods and services. Escalating protectionism, moreover, might extend and/or intensify the dollar’s recent decline.
UK
Rate Cut Likely in the Near Term November 16, 2007 By David Miles | London, Melanie Baker | London The Bank of England’s latest Inflation Report was one of the gloomiest documents it has produced in the 10 years since it became independent. We also think it is realistic in seeing the most likely outcome that growth next year slows sharply in the That is a profile almost exactly in line with what has been our long-held view: that rates will soon move nearer to what we judge to be a neutral level of 5.25% — two 25bp rate cuts below where we stand today. A rate cut as soon as the next meeting (December 6) is a strong possibility, and the Governor said clearly in the press conference accompanying the report that rate decisions at the next few meetings will be heavily dependent on the data releases. We expect activity indicators to weaken over the next couple of months — a view consistent with the first piece of significant data coming after the Bank Inflation Report, which today showed that retail sales fell slightly in October. Bank forecast lower GDP growth; higher near-term inflation: The Bank has significantly lowered its central GDP growth projection for next year. Its GDP fan chart — which illustrates a central forecast but also shows bands within which outcomes may fall with assessed probabilities — shows a central forecast of GDP growth slowing to around 2.0% by about mid 2008. Our best guess is that growth will be a bit lower than this. While the Bank forecast suggests that a period when GDP growth actually falls (relative to four quarters earlier) is a fairly remote probability event — with a weight of less than 10%; the chances that we get two successive quarters of falling GDP are significantly higher. The risks to the central forecast for growth in 2008 are disproportionately weighed to the downside. In contrast the risks around the central (fairly benign) inflation forecast are judged to be balanced. What the forecasts really mean: These Bank forecasts are unambiguously the collective view of the rate-setting Monetary Policy Committee (MPC) and not just a projection by staff economists. They are forecasts conditional on a market-implied profile for the policy rate, which is 25bp lower in 1Q08, with another rate cut coming later in 2008 and rates at 5.1% by end-2009. Very clearly this does not mean that the Bank is pre-announcing a timetable for rate cuts. Equally clearly, however, it means that if events pan out in a way that does not lead the Monetary Policy Committee significantly to change its views, we shall see a strong case to cut rates — and soon. The MPC now judges that uncertainty on the outlook is higher than in the recent past. This is inevitable given the scale of the potential knock-on effects of the credit crunch — which came in a situation where there already existed great uncertainty about how consumer spending would evolve after earlier rate increases, and where the savings rate had fallen to near an all-time low. In fact, we suspect that the Bank forecast underestimates the uncertainty about the growth profile as well as being still somewhat optimistic. One reason why our central GDP forecast is a bit more pessimistic than that of the MPC is that the Bank’s central forecast seems to incorporate a more optimistic assessment of the likely medium-term effects of recent turbulence in financial markets. The Inflation Report has a chart that shows three-month interbank rates derived from forward rate agreements relative to future expected policy rates. This chart implicitly suggests a rapid return to ‘normal’ conditions. By about May next year, the spread is back to pre-turbulence levels. It is unclear to what extent this expectation is incorporated into the Bank’s central forecast, but it could certainly be regarded as erring on the optimistic side. The Bank’s assumptions on the medium term re-pricing of risk in bank lending rates also look relatively optimistic. The assumption is that over the medium term, the average premium over the policy rate for lending to households and businesses will rise by only about one-quarter of a percentage point relative to ‘pre-turbulence levels’. Again, we would judge this as erring on the optimistic side — particularly for household lending. Bottom line for the near-term interest rate outlook: No-one now is likely to be surprised by rate cuts from the Bank — a big change from the position just a few months back. We still think a rate cut as soon as the next meeting is a strong possibility, and the Governor said clearly that rate decisions at the next few meetings would be heavily dependent on the data releases. To some extent the market may now be pricing in an implausibly aggressive path of rate cuts from the Bank of England. Yields on two-year gilts sit at around 110bp under today’s policy rate — a level that would seem to imply at least four, and quite possibly five, rate cuts of 25bp each. That is certainly possible — and it is an outcome to which we have explicitly given a significant probability in our own assessments of the scale of rate cuts. (For example, we have judged that by as near as June of next year, there is about a one in nine chance that rates are at 4.75% or lower.) But it is not our central forecast and — self-evidently — it is not what the Bank of England expects its own future rate decisions to be.
Currencies
China’s Private Sector Is US$1.2 Trillion Short of Foreign Assets November 16, 2007 By Stephen Jen | London, Charles St-Arnaud | London Summary and conclusions Residents of emerging market (EM) economies will likely be the next wave of countries divesting their home assets. These structural flows will impart a powerful bias in the currency markets, partly offsetting the large capital inflows that have begun to enter Financial diversification by the In our view, financial globalisation has been a major driver of exchange rates in recent years. Economic decoupling and regionalisation have bolstered the case for financial globalisation, as financial diversification makes more sense if the world is out of sync. We have witnessed, in recent years, huge diversification outflows from both the In The Biggest Dollar Diversifiers Are American (July 19, 2007), we pointed out that US real money institutional investors have about US$20.7 trillion under management — roughly 3.5 times the size of the world’s total official foreign reserves — and that they have been steadily diversifying out of USD assets since 2003. The motivation for such a tectonic shift in asset holdings is in dispute. Part of the reason reflects the desire to diversify, to raise US investors’ exposure to other parts of the world. On the other hand, this move may also reflect some investors’ bearish outlook on the Similarly, for Large diversification flows — other than the currency-rebalancing exercise undergone in some foreign central banks — have been powerful undercurrents in the currency world, forcing the dollar and the JPY below their values that are consistent with the economic fundamentals. We believe that, in the coming years, we will witness a similar trend in large EM economies that have accumulated enough wealth and attained adequate confidence and knowledge about the international capital markets. In other words, while many of these EM economies have been acquiring foreign assets through their central banks and SWFs, we believe that the private sectors of these economies will be major exporters of capital to both the developed markets and to other EM economies. The case of A key policy objective of We make the following points: Point 1. Point 2. Point 3. Future profile of USD/CNY will be significantly influenced by these private outflows. The potential for the Chinese private sector (both corporations and households) to export capital beyond Greater China (including Hong Kong) is significant, and is not something investors should ignore. While there is a lot of attention on Point 4. Diversification by other EM economies could be substantial. As Bottom line The ‘home bias’ of
Currencies
GCC: Transforming Oil into Financial Wealth November 16, 2007 By Stephen Jen | London, Luca Bindelli | London Summary and conclusions The GCC members should aggressively accumulate wealth through their SWFs, in our view. Not only is this strategy sensible from a financial perspective, but aggressively converting wealth ‘underground’ (in the form of oil) to wealth ‘above ground’ (in the forms of financial or physical assets) would have important non-financial benefits to these economies. GCC has US$44 trillion worth of proven oil reserves The six members of the GCC ( For the GCC countries, the ratio of the wealth ‘underground’ and that ‘above ground’ is around 28 — significantly above the ratio of 6 for Norway, which has been aggressively transforming oil and natural gas wealth into financial wealth for the past decade.[1] Thus, even though the SWFs of the GCC countries are already among the biggest in the world, in light of the size of their proven oil reserves, they are still relatively ‘young’ in this transformation from oil to financial assets, and should grow substantially larger in size over time. It make sense for GCC members to sell oil and buy equities Essentially, the GCC countries face the choice of, on the one hand, leaving the oil underground and waiting for it to appreciate in value and, on the other, extracting it, selling it and converting it into financial wealth. Extracting and selling their crude reserves is not the same as ‘spending’ their wealth, but rather a transformation of one form of asset holdings to another. The objective question, therefore, rests on the financial merits and demerits of doing so. As Deputy Governor Knut Kjaer of the Norges Bank pointed out, from a long-term perspective, real equity returns have far outstripped real returns on bonds, money markets or oil. Though oil prices in the coming years may continue to be squeezed higher, there is considerably higher volatility associated with oil prices than with equity prices. The composite value of equities has risen close to 400-fold, while bonds, money markets and oil have risen less than eightfold. The justification for the GCC countries to convert wealth in the form of oil to ‘higher-octane’ assets such as equities makes a lot of financial sense, purely from an expected returns perspective. The oil and equity price volatility consideration Not only have equities had a far superior track record in terms of expected returns, they also have a much better risk profile, as we mentioned above. Looking back over the past century, oil has been a relatively low-return but high-volatility asset, while equities are a high-return and high-volatility asset.[2] Bonds act as a counter-weight to equities to help achieve the risk-reward balance that is preferred by the owner of the portfolio. Our guess is that the GCC countries may have a 30:40:30 split between bonds, equities and alternative investments. If we are wrong with this guess, the chances are that their exposure to bonds may be less than 30%, and their exposure to alternative investments may be higher than 30%. In any case, the optimal portfolio, from a financial perspective, is one that has a high exposure to equities. Thoughts on the GCC’s SWFs We have the following thoughts on the GCC’s SWFs, to add to those we have expressed in the past: Thought 1. The GCC should continue to build on their SWFs. The GCC countries are, in the aggregate, exporting US$610 billion worth of oil per year at today’s oil price (GCC total oil production was 18.4 million barrels per day in 2006). In theory, as long as oil prices remain reasonably supported and oil production capacity is enhanced by the recent investments, the GCC’s SWFs should grow rapidly; this was our assumption when we issued the long-term projection for the world’s SWFs.[3] A related question is whether Canada should also have a SWF that goes beyond the scope of the Alberta Heritage Fund. This would help shield the Canadian economy from large swings in oil prices and could be a source of national wealth. Thought 2. Risks of a global recession, and the correlation between oil and equity prices. Intrinsically, the GCC’s wealth, both oil and financial, is not well diversified, as oil prices and global equity prices tend to be broadly positively correlated. If the Thought 3. Spend on infrastructure. The total population of GCC member countries is a relatively modest 33 million, with Thought 4. Currency diversification. The exchange rate regime and the currency composition of the SWFs should be separate considerations. The widely held presumption that the GCC will abandon the dollar peg and adopt a basket peg, as the Governor of the Central Bank of UAE al-Suweldi suggested earlier this week, should not be a new dollar-negative factor. Having said this, the SWFs of the GCC, being public funds for the future generations, should have a currency composition consistent with the likely import basket. This means that some dollar diversification is justified. We will have a more detailed discussion on the issue in the future. Bottom line There are compelling reasons for the GCC countries to continue to accumulate wealth under their SWFs. With US$44 trillion in oil wealth underground, to be converted into financial wealth, the current SWF holdings of US$1.5 trillion of financial wealth reflect a fraction of this multi-generational oil-to-equities transformation. -------------------------------------------------------------------------------- [1]In this note, we draw on a speech given by Deputy Governor Knut Kjaer of the Norges Bank, From Oil to Equities, November 2006, which justifies Norges Bank’s Government Pension Fund — Global. [2]In the coming years, oil prices are likely to remain on a structural uptrend. However, we think it is likely that equities will continue to outperform. [3]See How Big Could Sovereign Wealth Funds Be by 2015? March 15, 2007. |
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