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Updated: Nov. 29.,2006 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven

Updated: Nov. 29.,2006 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven. Cost of Foreign Exchange (EOCFX) and Shadow Price of Non-Tradable Outlays (SPNTO). Definition of EOCFX and SPNTO.

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Updated: Nov. 29.,2006 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven

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  1. Updated: Nov. 29.,2006 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture Seven

  2. Cost of Foreign Exchange (EOCFX) and Shadow Price of Non-Tradable Outlays (SPNTO)

  3. Definition of EOCFX and SPNTO • These variables (EOCFX and SPNTO) are estimated to measure the value of the distortions created when funds are sourced in the capital market and used to purchase either tradable goods (EOCFX), or non-traded goods (SPNTO). • These actions are repeated many times for each project and are identical for such actions across projects. • It is efficient and to estimate these variables once for a country and use the same values repeatedly as needed. • To make the estimates general we do not include the specific distortions on the particular traded or non-traded good. These effects are included when we estimate the economic cost of the specific item.

  4. Estimation of Economic Exchange Rate and Premium of Foreign Exchange under two situation: • Project already has raised funds e.g. foreign aid and spends them on traded goods. • Project raises funds in capital markets and spends funds on • Traded goods (Premium of Foreign Exchange) • Non-traded goods (Shadow price of non-traded outlays (SPNTO))

  5. Economic Cost of Foreign Exchange • When the numeraire is the domestic currency at the domestic price level, the foreign exchange effect of the change in the demand (or supply) of tradable commodities must be converted into domestic currency. • Conversion should take place at the “shadow exchange rate,” or economic price of foreign exchange (Ee). Cases: 1. Market Exchange Rate • If there are no distortions on the demand or supply of tradable goods, and if the exchange rate is determined by market forces, then the economic price of foreign exchange is equal to the market exchange rate (Em).

  6. Economic Cost of Foreign Exchange (Cont’d) • Trade Distortions • Trade distortions will change the demand and/or supply of foreign exchange such that the market exchange rate no longer measures the economic price of foreign exchange. For example, • Tariffs- lower the market demand for foreign exchange and cause Em to be less than Ee • Export Taxes - Decrease the market supply of foreign exchange and cause the Em to be greater than Ee • Export Subsidies - Increase the market supply of foreign exchange and cause the Em to be less than Ee • Indirect taxes will impact the demand and supply of both traded and non-traded goods • Value added taxes • Excise taxes

  7. All goods are divided into three types: 1. Importable 2. Exportable 3. Non-traded goods • Importable and Exportable goods are referred to as TRADABLE GOODS. • Prices of TRADABLE GOODS are determined by international markets and expressed in units of a foreign exchange currency. • Domestic prices of such goods are determined by multiplying the internationally given import price PIwor theexport pricePEW by the market exchange rate EM i.e. PDI =EMPIw, PDE=EMPEw

  8. As the world prices of these goods are fixed their domestic prices, and the quality domestically demanded or domestically supplied of these will depend on the real exchange rate (inflation =0) • Their quantities can be expressed in units of foreign exchange. • Importable and Exportable goods can be aggregate to make market for tradable goods. • This market is also the market for Foreign Exchange. • This market will determine the country’s real exchange rate.

  9. Demand for Traded Goods Equals Demand for Importable Goods plus Demand for Exportable Goods Demand for Importable Demandfor Exportable Demand for Traded Goods Goods Goods EMEM EM DT=DI+DE DI DE Q (FX) Importable $FX Q (FX) Exportable $FX Q (FX) Traded Because the world price of importable and exportable goods are given to country the demand for tradable goods is a function of the Real Exchange rate.

  10. Supply of Traded Goods Equals Domestic Supply of Importable Goods plus Domestic Supply of Exportable Goods Domestic Supply ImportableDomestic Supply Exportable Domestic Supply Traded Goods Goods Goods EM SI EM SE EM ST=SI+SE EM0 EM0 EM0 DT QSI QSE QT Q(FX) Importable Q (FX) Exportable Q (FX) Tradable Exchange rate determined by the demand and supply of tradable Goods QDT=QST

  11. Demand for Foreign ExchangeAn equivalent way to see how the exchange rate is determined as to draw the demand for imports and supply of exports Importable Market Demand for Imports P SImportable EM _ EM0EM0 EM1DImportable E1 DM QIS Import QID Q Importable(QFx)QFXD The demand for imports=Demand for importable goods-Supply of importable goods Demand for Foreign Exchange=Demand for Imports QFxD=QID-QIS

  12. Supply of Foreign Exchange Exportable Market Imports and Exports PSExportable SX _ EM0 _ EM1 E1 DM DExportable QED Export QES Q Exportable(QFx) QFXD/S QFxS=QES-QED=Supply of Foreign Exchange =Supply of Exports=SX

  13. Total Economy=Market for Tradable Goods plus Market for Non-Tradable Goods Tradable Goods Non-Tradable Goods EM ST SNT E0 PNT DT DNT QT0 Q(FX) QNT0 • Because there is a given amount of capital and labor in country, GDP=Quantity Supplied of Tradable goods + Quantity Supplied of Non-tradable goods. • Price of non-traded goods is fixed as the numeraire price in the economy (market equilibrium determined by relative prices). • Real Exchange rate determined in traded goods market. • Real Exchange rate is the relative price of Traded to Non-Traded Goods. • Changes in exchange rate will cause the demand and supply of Non-Traded goods to shift. This is the relative price effect on demand for a good.

  14. Full Employment and Equilibrium in Tradable and non-Tradable Goods Markets Tradable Goods Non-Tradable Goods EM ST0 SNT E0 PNT DT0 DNT QT0 Q(FX) QNT0 GDP=QT0+QNT0 Full Employment Should think of tradable Goods and Non-Tradable Goods as two large composite goods QST=QDT QSNT=QDNT

  15. Economic Equilibrium Importable Exportable Market for Foreign Exchange EM SISX SE E0 DI DE DX QSI QDI QDE QSE QFX0 ImportExport Equilibrium in Traded goods market also means that there is equilibrium in foreign exchange market. QDI +QDE =QDT QSI+QSE=QST In equilibrium QDT=QST Hence QDI+QDE=QSI+QSE QDI-QSI=QSE-QDE Imports=Exports

  16. Exchange Rate: # of units of domestic currency per unit of Foreign Exchange S0fex Ee=Em D0fex Q0 Quantity of foreign exchange US$ Em= Market Exchange Rate Ee= Economic Exchange Rate S0fex= Supply of foreign exchange as derived from supply of exports D0fex=Demand for foreign exchange as derived from demand for imports Ee = Ws * Em +Wd * Em as Ws +Wd = 1 then Determination of Market Exchange RateNo Distortions Ee=Em

  17. Exchange Rate • Case One: Project already has funds from Foreign aid • Import Tariff = Tm S0 E0m(1+Tm) m1 E E m0 Dt+project D0 Dt (net of tax) Quantity of Foreign exchange Traded d1 s1 Q Q0 Q Ee = Ws * Em +Wd * Em(1+Tm) Determination of Exchange Rate with Distortions

  18. m1 E E m0 Determination of Exchange Rate with Distortions Exchange Rate • Case Two: • Export Subsidy = kx S0 S0+export subsidy E1m(1+kx) E0m(1+kx) D0 + Project D0 Quantity of Foreign exchange Traded s1 d1 Q Q0 Q Ee = Ws * Em * (1+kx)+ Wd*Em

  19. Exchange Rate • Case Three: • Export Tax = tx S0+export tax S0 m1 E E1m(1-tx) E m0 E0m(1-tx) D0 + Project D0 Quantity of Foreign exchange Traded s1 d1 Q Q0 Q Ee = Ws * Em * (1-tx)+ Wd*Em Determination of Exchange Rate with Distortions

  20. Case Four • Market Determined Exchange rate • Current Account in Equilibrium • Import Tariff = Tm • Export Tax = tx Exchange Rate A B Tariff St S m1 E Export Tax L E m0 J D H G F Dp Quantity of Foreign exchange Traded Dt s1 Q d1 Q Q0 Ee = Ws *Em * (1-tx) + Wd * Em * (1+Tm) Determination of Exchange Rate with Distortions

  21. S A B J L K N H D m1 m0 E E M G DP F Dt s0 s1 d1 d0 Q Q Q Q Determination of Exchange Rate with Distortions and Capital Flows Exchange Rate • Case Five: • Market determined Exchange Rate • Balance of Payments Deficit Sustained through Capital Inflows • Import Tariff = Tm • Export Tax = tx St Quantity of Foreign Exchange Traded Ee = Ws * Em * (1-tx) + Wd * Em * (1+Tm) Conclusion: No change in basic estimation procedure.

  22. s = s - d * (Qd/Qs) Ws - d * (Qd/Qs) = s - d * (Qd/Qs) Wd Economic Price of Foreign Exchange Trade Distortions • An increase in demand for imported inputs will cause a (slight) depreciation in the domestic currency, which in turn will cause a reduction in imports and an increase in exports • The economic value of the foreign exchange required by a project is determined by the economic values of the forgone imports and increased exports Example: The main trade distortions are tariffs on imported goods and taxes on exports. The economic price per unit of foreign exchange is Ee = Ws * Em * (1-tx) + Wd * Em (1 + Tm) Where Ws = The proportion of an extra unit of foreign exchange that is met by an increased supply of exports: Wd = The proportion of an extra unit of foreign exchange that is met by a reduction in other imports:

  23. FEP = Calculation of Foreign Exchange Premium If the elasticity of foreign exchange supply (s) is equal to the elasticity of foreign exchange demand (d): s = - d Then, a simple way to calculate the foreign exchange premium is: Tariff Revenues + Export Subsidies - Export Taxes Value of Imports + Value of Exports

  24. Example for Indonesia (1991) Ee = Ws * Em* (1 - t xadj) + Wd * Em * (1 + Tadj) The Economic Cost of Foreign Exchange is calculated as follows: Where: Ee = Economic exchange rate Em = Market exchange rate = 1,950.3 Rp/$1.0 Ws = Weight on supply = 0.33 Wd = Weight on demand = 0.67 t xadj = Weighted average rate of tax on price-responsive exports = 0.00157 Tadj = Weighted average rate of tariff on price-responsive, non-re-exported imports = 0.0919 Therefore, Ee = 0.33 * 1,950.3 * (1-0.00157) + 0.67 * 1,950.3 * (1+0.0919) = 2,069.38 Foreign Exchange Premium (FEP) = Ee/Em - 1 = 0.061 Note: The market exchange rate is obtained from International Financial Statistics, October 1992. Data for oil and non-oil imports and exports, and for re-exported imports, are from the Central Bureau of Statistics. Data for government imports are from the Quarterly Report of Balance of Payment, April 1992, Central Bank of Indonesia. Data for import duty and export tax are obtained from Ministry of Finance, Nota Keuangan 1992/93.

  25. Application of Foreign Exchange Premium • To value tradable goods at economic prices, the CIF prices of importable goods, or the FOB prices of exportable goods should be converted into domestic prices using the economic exchange rate (Ee). • Alternatively, this valuation at economic prices can be achieved by adding a foreign exchange premium [(Ee/Em) - 1] per unit of foreign exchange demanded (or supplied) by a project.

  26. Economic Cost of Foreign Exchange Step1: Project Borrow 600 from Domestic Capital Market Tradable Goods Non-Tradable Goods EM ST0 SNT 400200 E0 PNT DT1 DT0 DNT1DNT0 QT0 Q(FX) QNT0 Assume: Demand for tradable goods is reduced by 400 and demand for Non- traded by 200. Total borrowing funds =Total reducing in demand for goods and services.

  27. 600 200 400 200 Step 2: Borrowed funds used to purchase 600 of traded goods Tradable Goods Non-Tradable Goods ST0 SNT0 Eu E0MPNT DT2 DTDT0 DNT1 DNT0 QT1 QT0 QT2 Q(Fx)QNT1 QNT0 Suppose all 600 is spent on Traded goods hence demand for Traded good shift from DT1 to DT2 .At the exchange rate of E0 there is now an excess demand of traded goods of QT2-QT0 or 200 and in the Non-traded goods market there is an excess supply of Non-traded goods of QNT0-QNT1 or 200

  28. Step 3: Exchange rate rises to E1 to reduce excess demand in Tradable goods market and excess supply in Non-Tradable goods market. Tradable Goods Non-Tradable Goods EMSNT1 ST0 SNT0 E1 E0PNT 80 120 DT2120 80 DT1 DT0DNT1DNT2DNT0 QT0 QT1 Q(FX) QNT1QNT2QNT0 Final Impact: Reduction in Tradable goods demand 400+120=520 Reduction in Non-Tradable goods demand 200-120=80 200 400 Assumption is that |TD| = 1.5 TS

  29. Step 1:Equilibrium in Market for Foreign Exchange Importable Exportable Market for Foreign Exchange EM SISX0 SX1 300100300100 E0 DI0 DI1DE0 DM0 DE1 DM1 QSIQDI1 QDI0 QDE1QDE0 QSE QFX0 ImportsExports Reducing in demand for Traded goods of 400 is assumed to reduce demand for importable goods of 300and a reduction in demand for exportable goods by 100. Hence, reduction in demand for traded goods of 400 gets translated into a reduction of demand by imports of 300 and an increase in supply exports of 100.

  30. Step 2: Equilibrium in Market for Foreign Exchange With the purchase of 600 of Traded goods (importable) there is an excess demand for foreign exchange of QFxD-QFxS or 200. Hence exchange rate must rise to E1. This will cause the supply of export to increase by 100 and the demand for import to decrease by 100. Assumption that |ID| = xS 600 300 100 100 100

  31. Financing of a Project by Borrowing from Abroad and Using Funds to Buy Traded Goods Step 1: No impact on consumer demand due to borrowing from Abroad Step 2: More Foreign Exchange to purchase traded goods for Project Traded Goods Non-Traded Goods E Step 2 Step 1 600 PNT E0 Q No Impact on Non-Traded Change in supply of traded goods (foreign exchange) increased by 600 and Change in demand for foreign exchange increased by 600 with the Project

  32. Market for Foreign Exchange No change in exchange rate as change in demand for FX of 600 is offsetted by additional supply of FX of 600 Step 2 Step 1 600

  33. Estimation of Shadow Price of Non-Tradable Outlays (SPNTO)Financing of Project by Borrowing from Domestic Capital Market and Used to Purchase Non-Traded Goods Step 1: Projects Borrows 600 from Domestic Capital Market Traded Goods Non-Traded Goods E 200 400 PNT QFX Assume: Demand for tradable goods is reduced by 400 and demand for Non-traded by 200. Total borrowing funds =Total reducing in demand for goods and services.

  34. Step 2: Borrowed Funds from Domestic Capital Market Used to Purchase 600 of Non-Traded Goods Traded Goods Non-Traded Goods E 200 400 400 PNT 600 QFX Suppose all 600 is spent on Non-Traded goods. Hence demand for Non-Traded goods shifts from D1NT to D2NT. At an exchange rate of E0M there is an excess supply of Traded goods of 400 (Q0T-Q1T) and an excess demand for Non-Traded goods of 400 (Q2NT-Q0NT) .

  35. Step 3: Exchange Rate Falls to Increase Demand for Traded Goods and Reduce Supply of Traded Goods Tradable Goods Traded Goods Non-Traded Goods E 200 400 400 PNT 240 160 240 160 QFX Final EquilibriumDemand for traded goods has decreased by - 400 + 240 = -160Demand for non-traded goods has decreased by -200 - 240 = -440 Total= -600 Assumption is that |TD| = 1.5 TS

  36. Step 1:Equilibrium in Market for Foreign Exchange Markets Importable Exportable Market for Foreign Exchange EM SISX0 SX1 300100300100 E0 DI0 DI1DE0 DM0 DE1 DM1 QSIQDI1 QDI0 QDE1QDE0 QSE QFX0 ImportsExports Reducing in demand for Traded goods of 400 from 600 of raising funds in capital market is assumed to reduce demand for importable goods of 300and a reduction in demand for exportable goods by 100. Hence, reduction in demand for traded goods of 400 gets translated into a reduction of demand by imports of 300 and an increase in supply exports of 100.

  37. Step 2:Equilibrium in Market for Foreign Exchange Markets Market for Foreign Exchange 300 100 200 200 With the purchase of 600 of non-traded goods there is an excess supply of 200 of foreign exchange. Hence exchange rate must fall to E2M . This will cause the supply of exports to fall by 200 and the demand for imports to increase by 200.Foreign Exchange Market EquilibriumStep 1: Reduction in demand for imports 300 Increase in Supply for exports 100Step 2: Increase in demand for imports 200 Reduction in Supply for exports 300Net Impact: Demand for Imports reduced by 100 Supply of Export reduced by 100 Total = 200 Assumption that |ID| = xS

  38. S0T S0T+BF 600 D0I 360 240 Financing the Project by Borrowing from Abroad and Using Funds to Buy Non-Traded Goods • Step 1: No impact on consumer demand due to borrowing from abroad. • Step 2: More foreign exchange available to purchase traded goods by others. Traded Non-Traded E E S0NT S1NT 600 E0 PNT E1 D1NT Change in demand for traded goods is increased by 360, change in demand for non-traded goods is decreased by 360. 240 360 D0NT Q D2NT Q0T Q Assumption is that |TD| = 1.5 TS

  39. Market for Foreign Exchange E SXFX SXFX 600 PNT E0 E1 DMFX 300 300 Q0T QFX 600 excess supply of FX from foreign borrowing results in falling real exchange rate to E1. This will cause the demand for imports to rise by 300 and the supply of export to fall by 300. Assumption that |ID| = xS

  40. TABLE 3 CALCULATION OF SHADOW PRICE OF NONTRADABLES OUTLAYS 600 of Project Funds Sourced Abroad And Spent on Non - Trad ables t m v t t v m h t Applicable v e m t is Distortion Alone v e h ia Change Due To (exclusion for Capital Market investment Sourcing e = 0.75) n.a. n.a. n.a. is Change Due To Real (exclusion for Exchange Rate investment Adjustment e = 0.33) ia Tradables Demand +360 v = .2 n.a. +72 +48 t Tradables Supply - 240 - n.a. n.a. t Import Demand +300 = .12 +36 +36 +36 m Export Supply +300 - n.a. n.a. Nontradables Demand - 360 v = .05 n .a. - 18 - 12 h Nontradables Supply +240 - n.a. n.a. Total Distortion Costs ( - ), +36 +90 +72 Benefit (+) Distortion Cost/ Project Expend. - .06 - .15 - .12 = Premium on Nontradables Outlays Shadow Price of Nontradable Outlays 0.94 0.85 0.88

  41. General expressions for premia on foreign exchange and shadow price of non-tradable outlays Definitions: • s1 = share of project funds sourced by displacing the demand for importables, • s2 = share of project funds sourced by displacing the demand for exportables, • s3 = share of project funds sourced by displacing the demand for nontradables, • f1 = fraction of a gap between the demand for imports and the supply of exports that is closed by a movement along the demand function for imports as the real exchange rate adjusts to bring about equilibrium, • 1 = fraction of a gap between the demand and the supply of tradables that is closed by a movement along the demand function for tradables as the real exchange rate adjusts to bring about equilibrium, • gd = fraction of project funds effectively sourced in the domestic capital market • gf = (1-gd) = fraction of project funds effectively sourced in the foreign capital market

  42. M = the uniform tariff rate on imports, • vt = the rate of value added tax on domestic consumption of tradables, • vh = the rate of value added tax on the domestic consumption of non-tradables, • Cs = share of reduced expenditure from the capital market sourcing of funds that are taxed by VAT, i.e. consumption. Cs = (1-eis) • Ca = share of reduced expenditure from the adjustment of the exchange rate that are taxed by VAT, i.e. consumption Ca = (1-eia) • eis = share of reduced expenditure due to funds sourced through the capital market that is excluded from the VAT base (i.e. investment) • eis = share of reduced expenditure due to exchange rate adjustment that are excluding from the VAT base (i.e. investment)

  43. TABLE 4 GENERAL EXPRESSIONS FOR PREMIA ON TRADABLES AND NONTRADABLES (Project Funds Sourced 100% in Domestic Capital Market) t With Uniform Import Tariff ( ) Alone: m t Premium on Tradables = (s + f s ) 1 1 3 m Numerical Check: .08 = [0.5 + 0.5(.33)]( 0.12) t Premium on Nontradables = [s - f (s +s )] 1 1 1 2 m Numerical Check: .02 = [0.5 - 0.5(.67)](0.12) t With Uniform Import Tariff ( ) Plus Value Added Taxes (v and v ) m t h (No Credit For Investment Goods) t d Premium on Tradables = (s + f s ) + (s +s )v + s v + s (v - v ) 1 1 3 m 1 2 t 3 h 1 3 t h Numerical Check: = .08 + (.67)(0.2) + .33(0.05) + 0.6(.33)(0.15) .26 = .08 + .1333 + .0167 + .03 t d Premium on Nontradables = [s - f (s +s ) ] + (s +s )v + s v - (s +s )(v - v ) 1 1 1 2 m 1 2 t 3 h 1 1 2 t h Numerical Check = .02 + .1333 + .0167 - (.6)(.67)(0.15) .11 = .02 + .133 + .0167 - .06 t With Uniform Import Tariff ( ) Plus Value Added Taxes (v and v ) m t h With Credit for Investment Goods t d Premium on Tradables: = [(s +f s ) ] + c [(s +s )v +s v ] + c [ s (v - v )] 1 1 3 m s 1 2 t 3 h a 1 3 t h Numerical Check: = .08 + (.25)[.1333+.0167)] + (.67)(.03) .1375 = .08 + .0375 + .02 t Premium on Nontradables: = [s f (s +s )] + c [(s +s )v +s v ] 1 1 1 2 m s 1 2 t 3 h d - c [ (s +s )(v - v )] a 1 1 2 t h Numerical Check: = .02 + (.25)(.1333+.0167) - .67[.6(.67)(.15)] .0175 = .02 + .0375 - .04 Note: c = (1 - e ) s is c = (1 - e ) a ia

  44. TAB LE 5 GENERAL EXPRESSIONS FOR PREMIA ON TRADABLES AND NONTRADABLES (Project Funds Sourced 100% Abroad) t With Uniform Import Tariff ( ) Alone m Premium on Tradables = zero t Premium on Nontradables = - f 1 m Numerical check - .06 = - (.5)(.12) t W ith Uniform Import Tariff ( ( ) Plus Value Added Taxes (v and v ) m t h (No Credit For Investment) Premium on Tradables = zero t d Premium on Nontradables = - f - (v - v ) 1 m 1 t h Numerical Check - .15 = - (.5)(.12) - (.6)(.15) t With Uniform Import T ariff ( ) Plus Value - Added Taxes (v and v ) m t h With Credit For Investment Premium on Tradables = zero t d Premium on Nontradables = - f - c (v - v ) 1 m a 1 t h Numerical Check - .12 = - (.5)(.12) - (.67)(.6)(.15) Note: c = (1 - e ) s is c = (1 - e ) a ia

  45. A Case of South Africa • A General Equilibrium Analysis • Take into account: - project funds sourced from the capital market (62.5% from displaced investment, 11.5% from household saving and 26.0% from foreign savings). - all distortions in import tariff, subsidy, value-added tax, and other indirect taxes.

  46. Table 2 Externalities Generated from Project Funds Sourced from Domestic Markets and Spent on Importables Capital Sourcin g and Spending Importables Exportables Non - Traded Domestic funds a) Project Demands for Importables +100.0 Displacement (K - Market) - 39.0 - 24.0 - 37.0 Effect of Real Exch Rate on Demand - 8.4 - 6.9 +15.3 Effect of Real Exch Rate on Supply +7.6 +14.1 - 21.7 Excess Deman d for Goods +45.0 - 45.0 0 Externalities: 8.21% Import Tariffs = (45 - 100)*3.6% = - 1.98% Production Subsidies = - (-45)*0.6% = + 0.27% VAT = [( - 39 - 24)*0.156 + ( - 8.4 - 6.9)*0.804]*11.36% +[( - 37)*0.156 + (15.3)*0.804]*6.54% = - 2.09% Other Indirect Taxes = ( - 39 - 24 - 8.4 - 6.9)*5.63% = - 4.41%

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