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CAN FINANCIAL LIBERALIZATION COME TOO SOON? JAMAICA IN THE 1990sAuthor(s): James W. DeanSource: Social and Economic Studies, Vol. 47, No. 4 (DECEMBER, 1998), pp. 47-59Published by: Sir Arthur Lewis Institute of Social and Economic Studies, University of the WestIndiesStable URL: http://www.jstor.org/stable/27866184 .
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Social and Economic Studies 47:4 (1998) ISSN: 0037-7651
CAN FINANCIAL LIBERALIZATION COME
TDD SOON?
JAMAICA IN THE 199?S*
James W. Dean
ABSTRACT
This essay argues that Jamaica's woes were triggered by premature
liberalization of her internal and extenl financial markets. It argues further
that liberalization in the long run can serve Jamaica well, but only if coupled wth a wide range of stabilization and prudential measures to avert further
crises.
The countries of the Caribbean...may gain from orienting their reforms to
wards a more competitive domestic financial sector and a more open
external financial sector. This should not mean that countries should rush
towards the liberalization of their financial sectors... a liberalization programme
should not be undertaken until a large measure of macroeconomic stability has been achieved, including careful and effective management of the money
supply and the fiscal account. This should be followed by the liberalization of
trade and the domestic financial sector and finally [emphasis added] the
liberalization of the capital account (El Hadj, 1997, p. 28).
The author acknowledges with gratitude informative interviews with Jamaican government officials and ministers, central, commercial and merchant bankers private sector economists, and academics. Without their information and insights this paper would not have been possible.
Pp 47-59
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48 SOCIAL AND ECONOMIC STUDIES
LIBERALIZATION AND ITS CONSEQUENCES
The political economy of financial liberalization in developing countries
Financial liberalization that began in the UK and the USA during the 1970s was followed by a world wide lifting of controls. Such controls typically in
cluded interest rate ceilings, restrictions on entry by both domestic and foreign financial institutions and on exit by the former, and barriers to the inward and
outward movement of capital. This was often accompanied by an overvalued
exchange rate. Liberalization usually meant a lifting of interest rate ceilings, a
relaxing of barriers blocking domestic financial institutions from establishing branches and subsidiaries abroad, allowing domestic residents to hold foreign securities and bank accounts and perhaps also to invest abroad directly, and a
loosening of restrictions on external payment of dividends, profits, capital
repatriation and disinvestment by foreign firms. As well, it often meant a
relaxing of restrictions on the inward flow of capital, such as those on entry of
foreign financial institutions, sale of securities to foreigners, borrowing abroad
by domestic banks and non-bank firms, access by foreigners to domestic equi
ties and real estate, and foreign direct investment.
The spread of liberalization to developing countries was sporadic and
often serendipitous. Small island economies were frequently induced to open
up their external and financial sectors by the twin carrots of membership in
free trade agreements and potential for offshore banking (Dean, 1993; Dean
and Felmingham, 1997). Others were prodded or even panicked into liberal
ization by balance of payments crises (Haggard and Maxfield, 1996). Jamaica falls into the latter category.
On the surface, the rapid and early deregulation undergone by certain
developing countries is puzzling, as it proceeded further than most developed countries at the time, and in retrospect was premature. For example Argen
tina, Chile and Uruguay all liberalized during the late 1970s, and later suffered
dire consequences (Edwards, 1984; Edwards, 1987; Edwards and Wijinbergen,
1986; Corbo and de Melo, 1985). More recently, in late 1994 and early 1995, Mexico's liberalization seemed to some to be premature. Although the lessons
for sequencing economic de-control are by now well documented (for example,
McKinnon, 1991; Sachs, Tornell and Velasco, 1996), both Mexico and Jamaica
appear to illustrate that these lessons are subject to pressure from the forces of
realpolitik.
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Can Financial Liberalization Come Too Soon? 49
Of course realpolitik often operates in opposing directions. Freeing up capital flows stands to harm private sector lenders and dealers in black market
foreign exchange whose rents would be eroded by foreign competition (Grosse, 1994). Governments often have even more to lose, benefiting as they do under
capital controls from the ability to run fiscal deficits financed by monetary creation without discipline from international lenders. Governments also stand
to lose powers of patronage toward sectors of the economy that they may, for
good reasons or bad, care to favour.
On the other hand as liberalization in the developed world proceeds, with the consequent increase in global economic integration, the balance of
realpolitik begins to shift. The opportunity cost of controls on the private sector increases, as do opportunities for evading such controls. Increased ex
ternal trade leads to greater incentives and occasions for under- and over
invoicing. Banks in their turn see opportunities for tapping international sources
of savings, and are tempted to open branches or subsidiaries abroad, particu
larly in New York and in the London Eurocurrency market. Governments find such operations increasingly difficult to monitor, difficulties that are exacer
bated by enhanced communications and travel possibilities. Indeed cheap air travel alone has made the enforcement of capital controls on individuals al
most impossible. Finally, foreign firms and financial institutions see opportu nities for profit in markets that are as yet relatively closed, and begin to lobby for looser controls on entry.
Although these trends might ultimately lead to liberalization in and of
themselves, their force has typically been strengthened by a balance of pay ments crisis. This might seem paradoxical, since a crisis should surely prompt government to tighten capital controls rather than loosen them. Yet between
1985 and 1990, when much of the developing world was mired in sovereign debt crisis, developing countries consistently and increasingly liberalized their
capital accounts: the number of liberalizing measures increased from twenty two in 1985 to a peak of sixty-two in 1988 before falling off to forty-nine in 1990 (Dean, 1992; IMF, 1992; Bowe and Dean, 1997). To be sure, in some cases (for example in Argentina, Mexico and Venezuela) the initial response to
the debt crisis in 1982-83 was to tighten controls against capital flight, but these responses were soon reversed. Prompted by this evidence, Haggard and
Maxfield (1996) undertook to examine the history of capital account policy in
four countries: Chile, Indonesia, Mexico and South Korea. They found that between 1970 and 1988, these countries revised their financial policies signifi cantly in eleven instances, of which eight involved loosening rather than tight
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50 SOCIAL AND ECONOMIC STUDIES
ening. Of these eight episodes, all except one originated in a balance of pay ments crisis.
By "balance of payments crisis" is meant, loosely, a sharp reduction in a
country's stock of international reserves that is not readily reversible by bor
rowing from abroad. Such a crisis might be precipitated by unsustainable do mestic monetary, fiscal or exchange rate policies, or by external developments
such as a sharp increase in international interest rates, a drop in demand for
exports, or a deterioration in the terms of trade. The crisis typically takes
shape as a speculative attack on the exchange rate, rapid capital flight, and withdrawal of voluntary private lending from abroad (Krugman, 1979).
Why should a balance of payments crisis prompt loosening, rather than
tightening, of capital controls? The answer is that the political position of those interests that favour liberalization is suddenly strengthened. Such inter ests include holders of foreign exchange, exporters, foreign creditors and in
vestors, foreign financial intermediaries, and the international financial insti tutions (IFIs): in short, the owners, earners and potential lenders of foreign exchange. Only if the capital account is liberalized will foreign exchange hold ers desist from (illegal) capital flight, exporters desist from false invoicing, and
potential creditors be prepared to resume lending.
Why Jamaica liberalized
Jamaica's rapid removal of capital controls in 1990 can be put in the context
just described. Throughout the late 1980s, Jamaica underwent a series of bal ance of payments "mini-crises." She was repeatedly bailed out by the IFIs, in
particular the IMF, which in turn pressured for liberalization. That this oc
curred fitfully at best can in part be explained by the continuing gratitude of
developed country lenders, particularly the USA, for Jamaica's fortitude under
the Seaga government in face of the socialist example set next door by Cuba. In
short, generosity from USAID and other bilateral lenders helped relieve heat
from the IMF: one measure of this is that the exchange rate actually appreci ated between 1987 and 1989. But in 1989, with the collapse of Soviet aid to
Cuba, bilateral G-7 loans and grants to Jamaica began to dry up. Jamaica was
sufficiently starved for foreign exchange that she submitted to pressure from
the Inter-American Development Bank (IDB) to dismantle capital and foreign
exchange controls, in return for a fast-disbursing trade and finance loan.
Thus at least one interest group, the IDB, became sufficiently critical to
Jamaica's short-term financial health that it succeeded in pressuring her to
remove capital controls, precipitously and in haste. It should be added that by
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Can Financial Liberalization Come Too Soon? 51
1990, a second and crucially important interest group, the Central Bank of
Jamaica (BOJ), also stood to gain from the rapid removal of capital controls.
Under capital controls, the BOJ had established the practice of borrowing US
dollars and other foreign currency abroad, buying Jamaican dollars domesti
cally at the current exchange rate, lending these to Jamaican importers and
others as suppliers* credits, and finally collecting repayment from these suppli ers in Jamaican dollars after 30-90 days. Once the exchange rate began to
depreciate rapidly, this practice left the BOJ with massive losses, since its for
eign currency borrowing on behalf of private sector suppliers translated into
greatly increased Jamaican dollar costs once the loans came due. Just as the
BOJ had profited from this practice when the Jamaican dollar was rising, it was
losing from it once it began to fall. The BOJ therefore was happy to cooperate with exchange rate liberalization, which would force the private sector to bear
its own losses on foreign exchange obligations.
Why Jamaican liberalization was premature
Wisdom with hindsight may be suspect. Nevertheless extensive and world
wide experience with liberalization over the last two decades has taught us a
number of lessons. Central to these are three preconditions. Firstly, trouble
free liberalization must be preceded by macroeconomic balance and stability.
Secondly, it must be preceded either by an exchange rate that is close to its
long-run equilibrium, official foreign exchange coffers that are full, or, prefer
ably, both. Thirdly, it must be preceded by well-capitalized and well-supervised financial institutions, as well as well-understood regulations governing the emer
gence of new institutions and new financial practices. None of these precondi tions held in Jamaica in 1990.
By 1990, Jamaica was running loose fiscal policy as well as loose mon
etary policy, a combination that was surely unbalanced. Moreover the overall
macroeconomy was verging on instability, in the dual sense that the fiscal
deficit was close to a Ponzi scheme, and monetary creation was beginning to
accelerate the rate of inflation. The fiscal deficit had risen to record heights and was rising further and faster, in small part due to bailout efforts stemming from the 1988 hurricane, but more fundamentally because external indebted
ness had been transformed into internal indebtedness.
This is a pattern common to many developing countries that incurred
foreign debt during the 1970s and early 1980s which then became unservice
able. Typically, central banks in such countries gradually assumed responsibil
ity for outstanding private sector debt in return for payments in local currency
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52 SOCIAL AND ECONOMIC STUDIES
or in local-currency denominated bonds. Thus the central bank of Brazil, for
example, would take over the foreign debt of a Brazilian firm in return for
payment in cruzeiros or cruzeiro-dominated securities. The rationale was that
the country's foreign debt became solely a public sector or "sovereign" obliga
tion, therefore permitting the government to negotiate from strength with its
creditors. A related consideration was that private sector generators of foreign
exchange might find it in their interest to pay foreign creditors more fully than
the government deemed to be in the national interest. The assumption of debt
obligations by the central bank was therefore made much easier if it was accom
panied by foreign exchange controls.
In the context of considerable domestic inflation and currency-deprecia
tion, the long-run consequence of governments' assuming of foreign currency
liabilities has been that they have been left holding greatly depreciated claims in local currency as assets. (The BOJ practice of borrowing foreign exchange on behalf of importers was a short-term example of this.) Except to the extent
that the consequent gap between assets and liabilities is met by taxation, it has to be met by issuing domestic government debt. Moreover, governments or
their central banks typically finance repayment and retirement of their foreign debt by further increasing their domestic debt. As a result, the excessive exter
nal debt that burdened so many developing countries in the 1980s has typi
cally been replaced by excessive internal debt in the 1990s. Jamaica, with mas
sive outstanding government debt, debt service payments and fiscal deficits, is a prime example.
Monetary policy in Jamaica has long been captive to fiscal policy, an
inevitable by-product of the country's British legacy of a weak central bank
subordinate to the financing requirements of the Department of Finance. Al
though the reasons for excessive monetary creation were varied, a core cause
was the BOJ's penchant for purchasing government debt and issuing deposits to the government in return: these latter then became part of the monetary
base. Thus as the fiscal deficit expanded, so too did the money supply. A
secondary cause was the inflow of capital from abroad, first as generous bilat
eral and multilateral lending to the Seaga government, and then as insurance
and other resource transfers from abroad after the hurricane of 1988. These
capital inflows typically were not sterilized; rather they added to the monetary base. The inflation rate jumped from 8.5% in 1988 to 17.2% in 1989, and the
Jamaican dollar began to depreciate sharply. Partly also as a result of capital
inflows, the exchange rate had appreciated from 1987 to 1989. By 1990, de
spite nominal depreciation, it was still overvalued in real terms.
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Can Financial Liberalization Come Too Soon? 53
Finally, Jamaica's banks, credit unions, and insurance companies were
under-capitalized, under-supervised, and under-regulated. In fact the oversights were legion, far too extensive to be documented here. For example, regulations
governing entry and capitalization by merchant banks and by credit unions were casual in the extreme. In the case of credit unions, they dated back to the 19th century. Regulations governing cross-lending between banks and mer
chant banks were also excessively lax or not enforced, partly because directors
could not be held liable for bad debts. Moreover government had extremely limited powers to assume control of a financial institution whose management
was clearly incompetent or corrupt. Deposit insurance did not exist. In the
context of macroeconomic instability and an overvalued exchange rate, Jamaica's
financial institutions were ripe for a roller-coaster ride from quick profits to
insolvency.
When deregulation of interest rates and capital controls came in 1990, the initial consequence was sharp depreciation of the Jamaican dollar. This
then fuelled inflation and led to further depreciation. The Bank of Jamaica was forced to respond with sharp increases in interest rates in order to attract
short-term capital from abroad and in order to arrest spiralling inflation, which
by 1991 had reached 80.2%. In order to fund its rapidly expanding deficit, the
Bank of Jamaica issued ever-increasing quantities of treasury bills, which drove rates up further, as high as 50% by mid-1992.
Commercial banks were (and still are) burdened with a 25% primary (cash) reserve requirement as well as a secondary requirement to hold 22-28%
of their assets as treasury bills. The latter became an extremely lucrative source
of income as t-bill rates climbed above 40% per annum. One consequence was
that, "comforted" by this income, some of the banks became overly casual about
the rest of their portfolio, extending uncollateralized loans and failing to pur sue arrears. As these arrears became public knowledge, a later consequence
was a "flight to quality" by depositors, who moved their money to the larger
indigenous banks as well as the three foreign banks. Two of the latter enjoy well established rural branch networks and stable, low-cost deposit bases, and
became "money-machines" at the same time as many of the indigenous banks
suffered from disintermediation. The woes of the indigenous banks were some
times shielded from scrutiny by the BOJ and Ministry of Finance because of
their ability to shift non-performing assets to merchant banks or building soci
eties with which they were allied. Finally, when monetary contraction had
became the order of the day, classic "moral hazard" and "adverse selection" set
in: banks dependent on interest-sensitive deposits, handicapped by the 25%
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54 SOCIAL AND ECONOMIC STUDIES
cash reserve requirement, under-capitalized and over-assured by the BOJ's fre
quent "loans-of-last-resort," began to extend loans at extraordinary interest
rates to borrowers of dubious quality.
By early 1997, after the failures in 1994 and 1996 of a small merchant
bank and a medium-sized commercial bank, and with the country's insurance
companies in liquidity crisis, the government had established a sort of resolu
tion trust called the Financial Sector Adjustment Company (F1NSAC), and
had committed itself to a J$6.3 billion aid package for the financial industry. In
addition, the Minister of Finance drew up a comprehensive "fast-track" bill for
re-regulating financial institutions.
WHITHER NOW?
Fiscal restraint
The government's most immediate challenge is to reduce its fiscal deficit. Unless it can do this, pressures to print money will prove irresistible, and the painful sequence of double-digit inflation followed by double-digit interest rates will recur. The Ministry of Finance finds itself in the unenviable position of antici
pating that upwards of 80% of its anticipated revenues for 1997-98 will be
absorbed by debt service. Meanwhile, certain public expenditure programmes,
notably education, have been squeezed to a point that severely undermines the
country's future.
Fiscal restraint can be achieved by increasing revenue, by reducing debt
service payments, or by reducing current and capital expenditure. There would seem to be considerable scope in Jamaica for broadening the tax base without
increasing tax rates. Part of this could involve better collection and enforce
ment, and closing loopholes. Part of it should also involve an overhaul of the
external tariff and duty system. Duties on price-inelastic and income-elastic
imports ? luxuries like high-priced automobiles ? should be raised or at least
enforced, whereas those on price-elastic and income-inelastic imports ? neces
sities like cooking oil ? should be lowered or eliminated. Such reforms would
also improve the distribution of after-tax incomes.
Debt service payments can only be reduced in the long run by using fiscal surpluses to retire outstanding debt. This ought to be one of government/s
top priorities, though it is difficult to implement in an election year since the
costs are immediate and the payoff is long-run. In addition the debt might be
restructured toward the long end; long-term zero coupon bonds would be ideal
but it is not clear that they would be saleable.
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Can Financial Liberalization Come Too Soon? 55
The potential for reducing current and capital expenditure is beyond this essay's scope, except to remark once again that whereas expenditure on
physical capital has been badly neglected, top priority ought to be given to human capital For example low-cost and highly effective motivational and educational programmes such as the Special Training and Empowerment Programme (STEP), which is targeted at high school dropouts, surely must
yield real returns in terms of productivity and crime reduction that exceed those of most private sector projects, not to mention most government expen
diture. Finally, there is potential for one-shot injections of revenue from
privatization. Alternatively, government corporations such as the Jamaica Pub
lic Service Company might be restructured with an eye to increasing efficiency.
Exchange rate options and coping with capital flows
In principle the ideal options for a country like Jamaica, which has lost credibil
ity in the eyes of external investors, is to commit itself to an exchange rate
regime that is purely market-driven and permits no role for government inter vention. Two polar regimes unambiguously tie government's hands: a currency
board, and a purely flexible rate. The arguments in favour of each are well known. They have in common the advantage of what might be termed "auto
maticity": that is, independence from the interfering hand of government or the central bank. A further advantage of a currency board is that, in contrast to a flexible-rate regime, it ties the country's inflation rate to an external an
chor: in Jamaica's case the obvious candidate would be the US dollar. A step beyond a currency board would be explicit replacement of the Jamaican dollar with the US dollar, as in Panama. Such a visible regime would undoubtedly be
perceived (wrongly) by the public at large as a disgraceful surrender of national
sovereignty. Nevertheless dollarization is apparently being advocated by an
important lobby group, the Private Sector Organization of Jamaica. The current Ministry of Finance is opposed to a currency board, per
haps because the short-run consequences of surrendering control over shocks
to money demand or money supply are formidable to contemplate. For ex
ample, a currency board regime would force contraction of the money supply in the face of a capital outflow or withdrawal of capital inflows, with a conse
quent hike in interest rates. Facing a massive bailout of the financial sector as
a result of recent interest rate spikes and having just now got interest rates
barely under control, the Ministry is understandably loath to risk another
episode. Although it was commonly alleged after the Mexican crisis of 1994 95 that the Bank of Mexico could have forestalled devaluation by refraining
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56 SOCIAL AND ECONOMIC STUDIES
from sterilizing capital outflows and allowing interest rates to rise, the Gover nor of the BOM retorted forcefully in the Wall Street Journal that this was not
an option because it would have triggered a banking crisis. Indeed Argentina,
which has a currency board, was hard put to avert bank failures in the after
math of the "tequila effect" that followed Mexico's troubles.
This leaves a fully flexible rate. Although flexibility runs the danger of
fuelling inflation, by the same token it provides a highly visible and potentially
embarrassing signal to the outside world of the extent to which a country is in
fact controlling inflation. In addition it provides a shield from the interest rate
or money supply shocks that volatile capital flows can impose on an open,
developing economy (Dean, 1996). For example the Mexico episode reinforced
calls in some quarters for a "Tobin tax" to deter speculative capital inflows and
outflows. A counter-argument is that speculative flows are deterred by volatile
exchange rates. Thus if central banks would cease and desist from all interven
tion in the foreign exchange market, including their customary short-run pur chases and sales to smooth fluctuations around the perceived "fundamental"
rate, they would find that their dilemmas about sterilizing speculative flows
would disappear because the speculators would stay at home.
Hedging against shocks to the external accounts
Whether Jamaica retains her present managed exchange rate regime or moves
toward less intervention, she could benefit from greater employment of mod
ern risk management techniques. These involve financial arrangements to pro
duce gains (or losses) that offset, at least in part, losses or gains resulting from
price, exchange rate, or interest rate volatility. Such arrangements take three
generic forms: futures, options and swaps. For example a futures or options
contract on the price of bauxite/alumina could be engineered to produce prof its if the price of bauxite/alumina fell, offsetting losses in export revenues.
Another arrangement, used for example by Mexico in the early 1990s, when
oil prices were volatile, is to issue bonds to external lenders with coupon or
even principal payments contingent on export (oil) prices, or even on export
revenue.
Although the exchange rate, interest rate, or commodity price risk on
any accounts payable or receivable can be hedged in principle via futures or
options, developing countries are replete with missing markets (for example there are no traded futures and options on the Jamaican dollar). Nevertheless
innovative techniques have been devised in recent years to bridge such missing
markets.
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Can Financial Liberalization Come Too Soon? 57
External (or internal) government debt contracted at a floating rate of interest could in principle be swapped with a counter-party for payments at a
fixed rate. Similarly, external debt denominated in pounds sterling might be
swapped for external debt denominated in dollars; this might be desirable if most of the country's export revenue is dollar-denominated (Mehran, 1986).
Techniques for debt management have now evolved to the point that computer
programmes design optimally-hedged portfolios of external debt (Claessens,
1991).
Optimal government intervention
We conclude with brief remarks on the extent to which a government in a
developing economy such as Jamaica's should intervene to do such things as
create missing financial markets, allocate credit, or promote saving and invest
ment. It is commonly argued that the Southeast Asian "miracle" economies
achieved their rapid growth in no small part from such intervention, much of
which runs counter to the conventional "Washington consensus" that empha
sizes laissez faire.
Firstly, it should be emphasized that the Asian economies, almost with
out exception, achieved their miracles in the context of low inflation and low
budget deficits, if not surpluses. That is, macroeconomic stability, a centrepiece of the Washington consensus, was also their sine qua non. Secondly, the Asian
economies typically liberalized financially only in the context of realistic ex
change rates and (fairly) well supervised financial sectors.
Nevertheless profound differences in philosophy prevailed and continue
to prevail between Asian economics and the Washington consensus. Several of
these are explored in Stiglitz (1996) and Stiglitz and Uy (1996). For example, because East Asian governments have typically not run deficits, they have
lacked markets for government securities and without that benchmark have
been slow to develop corporate bond markets. Recently, governments in Hong
Kong, Malaysia, Singapore, Korea and Taiwan have intervened to foster their
bond markets.
A question for Jamaica is whether and how the government should at
tempt to foster direct financial markets alongside her financial intermediaries.
Jamaica like most developing countries is disproportionately dependent on
banks for mobilizing credit, relative to more developed economies. A related
question is whether Jamaica should foster long-term credit allocation via devel
opment banks. In many Caribbean and Latin American countries these be
came sinkholes for government subsidies. Yet as Stiglitz and Uy (1996) point
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58 SOCIAL AND ECONOMIC STUDIES
out, in East Asia they succeeded. One lesson may be that development banks should be capitalized, owned and operated independently of government, with the latter's role limited to providing the legislative preconditions for their emer
gence.
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