Brad Setser

Brad Setser: Follow the Money

David Wessel visited the Harvard economics department

by Brad Setser Friday, October 29, 2004

Or at least talked to Summers and Rogoff, before writing his Thursday Wall Street Journal column. It is worth reading if you have access to the Journal. I agree with his bottom line: getting out of the current mess will take a bit of luck and policy action in the US, Europe, Japan and emerging Asia — and that hard work ought to start the day after the election.

Working on emerging economies taught me that there is a reason why crisis prevention is not easy — countries (and political systems) have to act before they are forced to by their creditors, in order to ward off concerns that have yet to materialize in full. That is hard. And make no mistake, the steps needed to reduce the United States trade and current account deficit won’t be all fun and games. We in the US depend on foreign savings to support the current market prices of many dollar denominated assets. Matthew Higgins and Thoman Klitgaard of the New York Fed have conducted a series of interesting calculations in a recent paper than illustrate just how dependent the US has become on foreign central banks to provide the dollar inflows needed to support current market prices for many dollar denominated financial assets. They note, using BIS data, that central banks built up $441 billion in dollar reserves in 2003, providing over 80% of the financing for the United States’ $531 billion current account (central banks in emerging Asia and Japan combined to provided 70% of the funding for the United States 2003 current account; oil exporters probably have stepped and are providing more of the overall financing this year). Private inflows, on net, provided only $90 billion of the needed financing for the current account deficit.

Indeed, the emerging Asian countries that financed the US in 2003 also attracted more net private financial flows than the US — well over $100 billion. That is money that could have been used to finance current account deficits in Asia. However, these countries did not spend their private capital inflows, but rater took the private inflows and used them to finance their purchase of central bank reserves! That’s how emerging Asia was able to buy $274 billion in dollar reserves (Higgins and Klitgaard estimate): $168 billion was financed by the region’s current account surplus, and a bit over $100 billion was financed by private inflows.

It seems pretty clear to me that the government policies are having an enormous impact on the pattern of global capital flows, even trumphing the impact of private markets. Take away the reserve flows, and something — probably including market prices for dollar assets — will have give either to attract more private inflows or reduce the United States need for external financing. Finding a way to ease US dependence on Asian reserves without triggering too much adjustment too soon will be a real challenge.

Exports of Treasuries, and other fun statistics

by Brad Setser Thursday, October 28, 2004

2004 US exports of goods (based on year to date trade data): roughly $800 billion.

2004 US exports of dollar denominated debt (based on the q1 and q2 balance of payments data): $800 billion.

It is not hard to see where the United States’ current comparative advantage lies …

The $800 billion number is not hard to generate: take the $670 billion expected 2004 current account deficit (a reasonable estimate if oil stays above $50), add in a net outflow of FDI of $130 billion (the net outflow in q1 and q2 was $65 billion), and assume that the TIC data accurately shows that the US is buying more foreign stocks than foreigners are buying US stocks, so that net portfolio equity inflows are either negative or a wash. Voila, $800 billion in exports of debt to fund the current account, FDI and the purchase of foreign stocks.

You also can get to $800 billion or more by doubling first half sales of reserve assets to foreign central banks($200 billion in the first half, double it = $400 billion), adding in private purchases of treasuries (annualized, that gets $200 billion), and then if you make some assumptions about portfolio equities outflows, a derived estimate of the sale of net debt securities from the overall securities data in the BOP (annualized, $300 billion). Annualizing the first half does produce the the best of all forecasts in this case, since Japan intervened bit time in q1 but not so far in the second half of the year. But it still gives you the basic numbers.

Adding in service exports makes everything a bit less dire, but the basic points stands. Our exports of debt securities have gone from $160 billion in 2000 to over $700 billion in 2003 to well above $800 billion if current trends continue in 2004. A growth industry if I ever saw one.

Another fun statistic, at least to me, though on an entirely different topic — emerging market debt.

World Bank outstanding loans: roughly $100 billion

IMF outstanding loans: also roughly $100 billion Outstanding emergingm market sovereign bonds in the EMBI (index of dollar denominated emerging market bonds): a bit more than $200 billion. The Wall Street Journal article on PIMCO’s El-Erian noted that he alone holds $15 billion of those bonds — a large share. But if El-Erian holds a lot of Brazil, the IMF holds way more.

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Morgan Stanley: China does not rely much on export led growth

by Brad Setser Wednesday, October 27, 2004

Sometimes you read something and it makes you stop, because it is at odds with your existing sense of how the world economy is working. Drossos and Kinbrough’s argument that China does not rely on a cheap currency to fuel an export-led growth model had that effect on me. They are making a comparative argument — other countries rely more on undervalued currencies and current account surpluses for growth than China. But the basic point, even upon reflection, still seems off.The hard part of their argument to swallow is this: China’s exports to the US are on track to rise by 30% this year, or by a bit less than $50 billion — the increase alone is about 3% of China’s GDP (though this will be partially offset by the imports China needs in order to export). China’s exports to the US are on track to double since 2000, rising from $100 billion to around $200 billion by the end of 2004, while overall US imports have gone up by only 20%. Nouriel and I are looking at data on exports to the US as a share of GDP, and China is among the countries that is most dependent on the U.S. market. That sure feels like export led growth.

Moreover, the entire Bretton Woods two hypothesis (see Nouriel’s blog) hinges on the argument that an undervalued exchange rate and rapid export led growth is so central to China’s overall economic prospect that they will incur all the costs associated with funding the United States deficits and sterilizing massive reserve buildup to maintain an undervalued exchange rate for some time.

One argument against the “export led growth” argument is that China’s overall trade is roughly in balance. That argument always struck me as a bit at odds with the facts. A 3% or so of GDP current accout surplus (2003) is not “roughly in balance.” The IMF estimates that China will –despite a massively negative commodity price shock and an overheated domestic economy — still run a current account surplus of 2.5% of GDP this year. 2.5% is not 5%, but it is not zero either. Moreover, as Morris Goldstein has emphasized, China’s underlying current accout surplus (in 2003) was around 5% of GDP, not 3% — a cyclical credit driven bubble was driving the surplus down. Compare that surplus with the deficit that China could run given its ability to attract FDI, and you get a gap of 7, even 8% of GDP. That is not small. There is a reason why China’s 2004 reserve accumulation is likely to exceed $100 billion.

Remember, when South East Asia was in the midst of a comparable property and investment bubble in 94, 95, and 96, large current account deficits were the norm. The surprise — given the scale of the adverse oil/ commodity shock and China’s own position in its economic cycle — is that China is still running a 2.5% of GDP current account surplus.

The other argument that could be made against an export-led growth thesis is that China’s imports are increasing quite rapidly (the pace of growth has tailed off a bit recently, but from a very high pace). That is no doubt true. But it also does not counter an manufactured export led growth argument. China’s exports are also growing fast, and part of the increase in imports is linked to the surge in exports: Chinese exports have a large imported component, both of things like computer chips and imported raw materials (see, among other things, my post on DeLong).

Of course, that is not the entire story. China’s imports are also growing because of a surge in demand for raw materials (and to a lesser extend capital goods) linked to China’s rapid growth. While some growth is linked to china’s emergency as an exporting powerhouse, some is also linked to an overall dyanmic created by rising income (accelerated by rapid lending growth). But even here, the observed surge in imports is overstated a bit by higher commodity prices, whether for oil, cooper, iron ore or soybeans. My bet is that if you looked at China’s 2004 import and export volumes, its export volumes are grow faster than its import volumes, DESPITE a massive domestic boom in China that is driving up import volumes (and contributing the overall run-up in commodity prices). If that is true, China’s overall trade surplus is falling slightly this year only because of an adverse move in import prices.

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DeLong on the global economy

by Brad Setser Monday, October 25, 2004

DeLong’s powerpoint notes are certainly worth checking out. The side by side graphs showing real GDP growth and then employment growth (or the lack thereof) elegantly tell the story of the 2002-2004 recovery.

However, I have a few comments on DeLong’s China slide.Professor DeLong makes two arguments. One is that the spectacular rise in China’s exports has largely come from changes in intra-Asian electronic trade, with more electronic components now being sent to China for final assembly. The other is to remember the principle of comparative advantage: The U.S. will have a comparative advantage over China in the production of something.

Actually, it is pretty obvious that we do have a comparative advantage over China in one thing — the production of budget deficits. I am being serious. To run a budget deficit, you have to be able to sell debt, and we are selling a lot of debt to China. 2004 US exports of goods to China are likely to be around $40 billion. China’s reserves are likely to rise by over $100 billion this year, and globally, the BIS reports that 2/3s of all reserve assets are in dollars. That would imply that the US is likely to export $67 billion of dollar assets to the Bank of China. In other words, our current comparative advantage is in the production of financial assets for sale abroad!

A brief aside. The data on China’s holdings of Treasuries shows a slightly slower pace of increase than I calculated above. China’s holdings of Treasuries fell a bit in January and February, likely because of plan to recapitalize state banks, but its holdings have since risen by about $20 billion. That would works out to an increase of about $40 billion for the year — less than the $70 billion I inferred from data on the growth in China’s reserves. China may be holding more agency bonds, may be hiding the size of its holdings of Treasuries by going through intermediaries, or just perhaps, may be holding fewer of its assets in dollars. But even at $40 billion, US exports of treasury bills to China will match US exports of goods to China in 2004.

DeLong’s broader argument gets part of the story right, but, in my view, not all the story. It is true that between 2000 and 2003, a lot of the growth in China’s exports to the US simply displaced other Asian exports. Overall US imports from the Pacific Rim were around $420 billion in 2000, and still around $420 billion in 2003 (US imports were roughly flat overall during this period, as imports fell sharply in 2001, both because of the recession and lower oil prices, and then picked up). However, looking forward, I suspect China will increasingly be moving into other markets. 2004 exports from the Pacific Rim are set to rise by $70 billion, to $490, driven by a $50 billion increase in imports from China — i.e. East Asia as a whole is increasing its share of the rapidly expanding US market for imports. Going forward, barring any major changes, overall imports from East Asia will keep on rising — i.e. Chinese goods will displace imports from other regions (say textiles) or US production, not just other East Asian production. Afterall, a $1.5 trillion or so economy that exports a ton and is investing 40% or more of its GDP has to keep moving into new markets.

DeLong is right to note that the US has to have a competitive advantage in something. China is earning a ton of dollars selling goods to the US, and those dollars have be used, not just hoarded. Recently, China has used those dollars to buy Treasury bills (and, no doubt, also to buy oil), but that is probably not the long-term solution. The problem, it seems to me, is that no one in the US really seems to have a good sense of where our future comparative advantage will be. I have not heard of many new investments in the US that are premised on supplying the growing Chinese market. Usually, the anecdotes are of the opposite — US firms moving to China to supply the US market.

Now I suspect that some of those firms are making a mistake, at least if they are assuming that China will retain all of its current cost advantage over the United States. If you are investing in a Chinese plant that will be at peak production between 2008 and 2010, and you are betting that the renminbi/ dollar will remain in the 8.2 range, then you are betting that the US will be able to run trade deficits of 8% of GDP or more in 2008. That seems implausible to me. Smart investors in China should assume significant real appreciation going forward.

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In the second Presidential debate …

by Brad Setser Monday, October 25, 2004

President Bush was asked to name three mistakes he had made. He declined, other than to hint that perhaps he had hired a couple of people he should not have (Paul O’Neill, I suspect he meant you). It seems to me that even my Republican friends ought to agree that this was something of a mistake. High density plastic explosives are generally best kept up locked up and under armed guard.

How Bush budget deficits ended up hurting Ohio

by Brad Setser Friday, October 22, 2004

Ronald McKinnon has an interesting argument in yesterday’s Financial Times (based on this policy brief), namely that manufacturing workers are paying for low US private savings and large US budget deficits. The counterpart to low savings is a large trade deficit, as the US depeneds on foreigners to save some of the money earn selling to the United States, and then to lend it back to the US. We have outsourced savings. McKinnon believes the solution is a smaller US budget deficit; Nouriel and I think you also need some exchange rate adjustment. But McKinnon’s basic argument is right — manufacturing employment would be much higher if the US was not so dependent on foreign savings (McKinnon suggests manufacturing employment would rise from 10.5% of the labor force to 13.9%, a change worth 4.7m jobs).

Philip Coggan’s FT column incidentally notes that the financial sector generated 38% of all US corporate profits in the first quarter of the year. That too is linked to the United States’ ability to import foreign savings, which is keeping interest rates lower than they otherwise would be (particularly with a large budget deficit) and thus is fueling both a lending/ borrowing boom and appreciation in the price of many financial assets. A credit boom, plus low short-term rates (banks still borrow short and lend long, in various ways) = big financial sector profits.Why are the two linked? Consider two states, one that tends to specialize in the production of manufactures (Ohio) and another that tends to specialize in financial services (New Jersey or Connecticut). Without the capacity to borrow from abroad, large budget deficits would tend to drive up interest rates in a low savings economy, crowding out domestic private investment. High interest rates also tend to depress the value of financial assets — and, of particular interest to residents of the East and West coasts, to depress the price of housing as well. All in all, that combination is not so good for New Jersey, or Connecticut.

Borrowing from abroad can change all that. So long as external financing is forthcoming, the low savings country can run large budget deficits without necessarily crowding out an expansion of private credit (This private credit recently has gone to households to finance consumption/ new construction more than to finance business investment) or driving up interest rates in a big way. That helps the financial sector, and it also helps regions either have lots of non-traded goods production (say, house construction)or that depend in part on the financial services industry. Say New Jersey.

However, foreigners cannot just print the dollars they are lending to the US. They have to earn their dollars by selling more to us than they buy from us. In other words, they must run a trade surplus (save) to finance their lending to us (our debt is their assset). That hurts regions — like Ohio — that still have large manufacturing industries.

At a minimum, a policy of budget deficits financed by external savings (particularly reserve accumulation) will have an impact on the composition of US output — notably by lowering the output of tradeable goods. Since manufactured goods still are easier to trade than services, and since certain parts of the country produce more manufactured goods than others, that will have an important impact on the distribution of output across states. I suspect that the economy also does not adjust perfectly smoothly, so a policy that relies on growing trade deficits to provide the savings foreigners need to finance growing budget deficits also likely has some impact on the overall level of employment, at least in certain regions. In other words, unemployment in places like Ohio is part of the adjustment process as the economy reorients away from the production of tradeable goods.

This game is in my view ultimately not sustainable — we are buidling up external debt way to fast, and cannot export 10% of GDP and import 16% of GDP for long (the US makes up the gap by exporting financial assets — or fastest growing export is US treasury bills!). At some point, resources will have to flow back into the production of things that can be sold abroad, and that too will generate its own frictions.

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The IMF staff report on Iraq is a goldmine

by Brad Setser Wednesday, October 20, 2004

I don’t expect many journalists will delve into it, but the IMF staff report on Iraq is a fountain of information. My favorite number: in 2004, the amount Iraq will spend importing (yes, importing) refined petroleum ($2.1 billion) will exceed the amount Iraq received in grant aid from the world (tranfers are projected at $2.05 billion). The refined gasoline that Iraq imports is then basically given away inside Iraq (the going price apparently is 1.7 cents a litre, which I think works out to less than 10 cents a gallon, though my metric conversion skills are a bit rusty) along with some gasoline Iraq refines itself, at a fiscal cost of $7 billion (or 30% of GDP, that is the IMF’s estimate of the cost of Iraq’s subsidy for domestic oil). Iraqis then take some of this cheap gasoline, put it on trucks, and ship it back across the border where it is sold at a profit, providing income and jobs for Iraqis (Iraq consumes an amazing amount of petroleum domestically for a $21 billion economy … ). The free market in action!

You may think I am making this up, but all apart from the oil smuggling story (which is pretty widely known, Iraqis smuggled oil out before the war, and from domestic consumption numbers, still do now) comes straight from the IMF, though you have to piece together the various parts to produce this tale …The estimated grant aid of $2.05 billion for 2004 is particularly disappointing. That is a tiny yield from the $18 billion plus in aid the US congress approved in 2003(see my earlier post on this) and the additional funds pledged by other countries at the Madrid donors conference. The net transfer of funds to Iraq is even less, only $1.2 billion, since Iraq is transferring $0.8 billion out of the country. This is almost certainly going to Kuwait, which is getting 5% of Iraq’s 16 billion in 04 oil export revenues to pay off the reparations the UN awarded for the first gulf war.

But net flows of grant aid (i.e. grants minus reparations) of only $1.2 billion is still way too small. The low number is partially the product of the deteriorating security environment, but it also reflects the fact that the Bush administration low-balled the cost of reconstruction going in (remember, oil, not the US taxpayer, was going to pay for everything, and fast). Consequently, the administration did not have a supply of appropriated funds ready to deploy immediately after “catastrophic success.” Rather, the US initially relied on unfreezing frozen Iraqi assets and the cash the US found in Baghdad. This, plus $2 billion in appropriated aid, was going to tide Iraq over until Iraq’s oil made Iraq self-financing … the dreams of early 2003.

The IMF staff report also delves into the free market wonder that is Iraq. Iraq is a country where government spending is more than a 100% of gross domestic product (2004 budget is $22.6 billion, 04 GDP seems to more like $21.2 billion, a rather amazing statistic). The state still intermediates most economic activity, and buys most of Iraq’s imports. Iraq’s economy is simple: the state basically uses Iraq’s oil revenue to finance Iraqi consumption, both directly by providing a range of goods and services to Iraqi, and indirectly.

— The government supplies gasoline for next to nothing, at enormous budget cost. Reselling that gasoline to neighbors where gasoline is less subsidized provides jobs and supports economic activity (tho Iraq has promised to reduce this subsidy going forward … let’s see if that is politically possible)

— The government also does not, it would seem, charge for electricity. When the electricity is on, it takes a loss there, paid for by oil exports.

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The Washington Post is also sounding the alarm …

by Brad Setser Wednesday, October 20, 2004

A friend brought this Washington Post article to my attention, as it takes on the topic of my last post. Like the FT article it draws on the the new Treasury data on foreign purchases of US securities to highlight the United States’ dependence on foreigners, and specifically, foreign central banks, to fund our budget deficit.

One point is worth reinforcing. The debate about whether Asian central banks will dump their existing holdings of Treasuries misses much of the point. Asian central banks don’t have to sell their existing Treasuries for the dollar to come under pressure; all they have to do is to stop buying new Treasuries. In order for the dollar to stay at its current levels, Asian and other central banks have to increase their holdings of dollar-denominated assets by at least $200 billion a year, probably more. If they don’t add to their holdings of Treasuries, the dollar will fall.

The FT has a good article on how the US is funding its trade deficit

by Brad Setser Tuesday, October 19, 2004

The Treasury provides monthly data on foreign purchases of US long-term securities. It is not a complete look at how the US is funding its trade and current account deficit, but it is the best snap shot out there. I usually have plenty to say, but I have (relatively) little to add to this FT article. The currency strategists quoted in the article hit on the key points. Weak portfolio equity inflows (in plain engligh, foreigners are not buying US stocks. Heavy dependence on inflows from foreign central banks (central banks provided over a third of the total monthly flows). Remember, the reported numbers on reserve accumulation by central banks understate, in all probability, real inflows from central banks, since a central bank that opens an account with, for example, a swiss bank to buy US treasuries won’t necessarily show up in the data. And total inflows that are only a bit bigger than what the US needs to fund its trade deficit.

The nasty numbers. The US trade deficit looks to be around $610-615 billion this year. Transfers (US foreign aid, and the money various immigrants send home to their families) look to add another $80 billion to the current account. Net investment income is likely to be positive, but Q2 numbers suggest it won’t be that positive — since we still earn more on our external assets than we pay on our external debt, these net earnings may subtract $20 billion from the overall deficit. That leaves a financing need from the current account of $670 billion, or about $55 billion a month. The US, though, also needs to fund net outflows of FDI (US firms are investing more abroad and foreign firms are investing in the US). If the trend of the first two quarters continues, the US needs to raise an additional $130 billion to finance FDI outflows, generating a total external financing need of $800 billion, or a little under $70 billion a month — i.e. more than the $60 billion the treasury reported. There are sources of financing not reported in the treasury capital flow data, namely net bank borrowing and it is certainly possible that foreign firms are investing more in the US in the later half of 2004 than they did in the first half. Nonetheless, the $60 billion monthly inflow number does suggest possible trouble funding both net FDI outflows and the current account deficit — there is reason why the data led the dollar to fall slightly. Looking ahead, the US financing need in 2005 is likely to be a bit bigger — the trade deficit is likely to be north of $650 billion, and with net transfers of say $80 billion and net payments on our growing foreign debt of say $20 billion, the total current account deficit would be in the $750 billion range (I think this is a relatively conservative forecast if oil stays in its current range). If net outflows of FDI continue, the total US financing need would be in the $900 billion range. And if foreigners continue to be reluctant to buy into the US stock market, that implies a need to sell $900 billion of US debt securities to foreigners. That is not a small sum. It is bigger than Brazil’s GDP. It is almost 2/3s of China’s GDP. It is not that much smaller than total US exports of goods and services. It implies average monthly inflows into US securities (assuming net bank flows are small) of $80 billion or so … we will see if that kind of inflows can be generated at current interest rates.

I am looking at this in detail because Nouriel and I are preparing to update our paper on US external sustainability. It increasingly seems to me that we will need to refine our forecast for 2005 a bit.

Guess why Treasury did not issue the foreign exchange report?

by Brad Setser Monday, October 18, 2004

The Treasury did not issue the foreign exchange report on Friday. Presumably, this is because it would have made the same set of arguments that last year’s report made, namely that China is not manipulating its currency. Not exactly something the Treasury wants to state publicly before an election.

The report puts any Treasury in a bind. The consequences of declaring a country to be manipulating its currency are so dire – basically trade war – that is always a strong desire to avoid finding manipulation. Better one or two days of public embarrassment than initiating a fight with China that might get out of control. The right policy here is pretty clear: use the threat of declaring China to be formally manipulating its currency to convince China to change. That requires a consistent policy to encourage China to revalue its currency that is pursued effectively over a long period of time, something I am not convinced the Bush Administration has done.

Revaluing the renminbi, by the way, is not something that is unambiguously against China’s interests: revaluing the renminbi (or yuan) would also help China avoid a dramatic expansion in its money supply that is fueling a domestic credit bubble (and rising inflation, now suppressed by administrative measures).

I don’t think there is much doubt that China’s peg is an impediment to effective balance of payments adjustment, and that is keeping its currency low in part for commercial gain. It clearly has more than enough reserves (now over $460 billion, and growing by about $100 billion a year), given that it has almost no external debt and given that China is not going to suddenly liberalize its capital account. China is a major net creditor to the world, yet it clearly is not expecting a positive financial return (in local currency terms) on its dollar reserves – I presume the Bank of China expects a financial loss when the dollar does depreciate against the renminbi, but views that financial loss as a price worth paying for strong, investment and export led growth now. It is true that China is not running an enormous current account surplus – but that is the wrong measure. As I have argued before, a country like China that is attracting 3% of GDP or more in FDI and with little external debt should be running a current account deficit in equilibrium, particularly if it is the midst of a dramatic boom in investment.

That is not to say that China’s willingness to finance our budget deficit cheaply unambiguously hurts the overall US economy: by keeping interest rates low, it helps interest sensitive sectors and supports the value of many financial assets, even as it hurts US manufacturing and regions of the country that depend on manufacturing. But even if the US does benefit in the short-run, the current pattern is unsustainable, and at some point, we will have to starting exporting more/ importing less. Adjusting to put our economy on a more sustainable footing won’t be easy; it will be extremely painful if the government does not reduce its own need for borrowing.

A final point. Treasury is right to note that the foreign exchange rate report is often not delivered on time – that is more often than not a result of the fact that no one cares about the report, and if neither the Congress nor the press is demanding the report, it is hard to get Treasury principals to focus on the report and clear it. I know – one of my first jobs at Treasury was to work on parts of the 1997 foreign exchange report – one of the reports that was never issued (it got wrapped into the 98 report). By the time that report was cleared, it was so far out of data that it was worth issuing. But at the time, there was no real question of currency manipulation (defined broadly as interevention to keep the currency weak for commercial gain) – Treasury was desperately trying to keep Asian currencies from falling further after Asia’s financial crisis. The US, through the IMF, was effectively lending Asia money to help prop up Asian currencies; right now, Asia is lending the US money to help prop up the dollar (and in the process, helping Asian exports). The situation is completely different.

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