The Role of Debt and Shadow Banking in China’s Economy

January 14, 2019

By Cindy Li and Paul Tierno

In this next episode of our series Rethinking Asia, we pick up where we left off last episode looking at the role of debt in China’s economy. We spoke with Charlene Chu, a senior partner for China macro-financial research at Autonomous Research, an independent research firm. Well known for her analysis of China’s shadow banking industry, Charlene previously was a senior director covering Chinese financial institutions at Fitch Ratings.

Charlene gave her assessment of the recent rise in Chinese debt and why she thinks a painless deleveraging is unlikely. While China has implemented some reforms in recent years, it has mostly avoided deleveraging. Previously, China relied on a high deposit base to support credit expansion, but new credit consistently outstrips deposit growth making the levels of credit growth unsustainable. Some of Charlene’s main takeaways include:

  • China’s debt-to-GDP has increased by nearly 150 percentage points since the Global Financial Crisis, accompanied by a $30 trillion increase in the banking sector. While other countries have experienced large increases in debt-to-GDP before, the size and scale of China’s economy makes the growth alarming.
  • The vast majority of China’s debt is in the corporate and property sectors. China has also experienced a run up in consumer debt over the last few years, but, currently there is no concern in households’ ability to service the debt.
  • One of the most troubling aspects of China’s debt problem is the surge in the more opaque and less regulated shadow banking sector. However, the merging of two regulatory bodies should reduce some of the regulatory arbitrage that has allowed off balance sheet lending to grow.
  • While a financial crisis is not preordained, Charlene dismissed the prospects of a “beautiful deleveraging.” Any attempts to deal with China’s debt burden will require hard decisions, including shuttering less productive companies by forcing them to realize losses, reining in shadow banking, capping credit growth, adjusting lending rates to account for risk, and accepting lower levels of GDP growth.


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Cindy Li:

Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Cindy Li.

Paul Tierno:

And I’m Paul Tierno. We’re analysts in the country analysis unit, and our job is to monitor financial and economic developments in Asia.

Today, we continue our series, Rethinking Asia, as we consider noteworthy and unusual trends in Asia in finance and economics. Last week we sat down with Yukon Huang, a senior fellow at the Asia Program at the Carnegie Endowment for International Peace, to discuss China’s debt. Here’s what Yukon had to say in that discussion:

Yukon Huang (excerpt):

I am fairly sanguine in terms of the increase in the debt, but I’m not so sanguine about the composition, the emergence of shadow banking, the role of the banks, the institutions, the financial development in this country, because that is still going through what I call a fairly piecemeal evolution that has not yet been really addressed seriously.

In today’s episode, we sat down with Charlene Chu, Senior Partner at Autonomous Research Asia, where she conducts China Macrofinancial Research and asked her to share her insights on this topic.

Cindy Li:

Charlene has written extensively about China’s banking sector risks, both at Autonomous Research and in her previous role as a China analyst at Fitch Ratings. She is well known for her analysis of China’s shadow banking system. And her work has attracted many followers. Charlene provides an overview of the scale and composition of China’s high level of debt, why that was bad for the economy, and how things have been evolving in recent years. She also voices her concerns of the shadow banking system, and makes some suggestions for how the right policies can help reduce regulatory arbitrage.

Paul Tierno:

Let’s get to our discussion!

Cindy Li:

Charlene, China has one of the highest debt-to-GDP ratios among the emerging economies. According to the latest BIS data, after a short period of deleveraging that GDP ratio is actually on the rise again. You have covered the Chinese financial market for a long time and also have warned about China’s debt problem. Maybe we can start by providing the audience with some background of the situation such as who’s borrowing and who’s lending. What’s the scale and most importantly, should we be worried and why?

Charlene Chu:

I think China’s expansion of debt is beyond something that we have really seen in recorded history in nominal terms. We have by our numbers and this is one of the issues in China that the official data is extremely problematic and so most analysts have their non-credit data, but according to our data at Autonomous Research we are looking at an increase of credit to GDP since 2008 of about 150 percentage points. Roughly from 126% to around 277% at the end of June this year. That is very substantial and BIS and other entities have done a lot of work on this over time just showing that a very rapid run up in this ratio in a short amount of time is one of the biggest predictors of the crises.

In nominal terms—and I only try to remind people the nominal scale we’re talking about—because it is common knowledge at this point, it wasn’t a few years ago but it is common knowledge at this point, that China has a debt problem. Most people just kind of accepted that and I focus on a lot of other things and think it’s not necessarily going to be an issue and I always try to remind them of the scale.

In nominal terms we’re talking about a banking sector in 2008 was around $9 trillion US dollars and at the end of June of this year is around $39 trillion US dollars so the delta in just 9-1/2 years is $30 trillion US dollars. By the end of next year if we keep up this pace of growing through 2019 that delta in 10 years is going to be equivalent in size to the entire US banking sector, Japanese banking sector and UK banking sector combined.

This is where I say this is just something we have never seen. We do often see large increases in credit to GDP in small countries. Hong Kong is a good example, Iceland was a good example but these are usually small locations. We don’t see it in very big economies like China and that’s what makes this such an important issue today.

Paul Tierno:

Picking up on that if we can get to the composition of the debt, who’s borrowing and who’s doing the lending?

Charlene Chu:

The vast majority of the problem resides with Chinese corporates and a very large portion of that is within property. Some of that property-related borrowing is not necessarily marked on the books as a loan to a property company because what we have in China is many state-owned enterprises, many private enterprises have property subsidiaries and the loans that are going to property will sometimes be on the books as going to the parent industry. You can have situations where property-related loans are being booked as loans to mining companies, manufacturers and that type of thing.

There is a larger share of property-related debt than the official data would suggest. It really comes down to a corporate sector and a property sector borrowing issue. Now more recently, I’d say over the past three years, we’ve started to see a much larger run up in consumer debt in China, credit card loans outstanding. The nominal balance is now larger than the US in size and that has happened in a very short amount of time.

When most people think about who is carrying the most credit card debt in the world people automatically think of the US and that is simply not the case. At the moment we now have more credit card debt in China so there is an emerging household debt burden but from a very low starting point and we are not at levels where we need to very seriously question the ability to service that household debt in the way that we need to be worried about the corporate ability to service their debt.

In terms of lenders, we’ve got about two-thirds of the increase in credit, so that’s $30 trillion US dollar increase in banking sector assets which is actually identical to our increase in outstanding credit. About two-thirds of that, so $20 trillion, has come in the form of loans and bonds. You can call that traditional sources of credits. The remaining one-third has come through what we would call non-traditional or shadow sources of credit and this can be hidden second balance sheets of Chinese banks which is their off balance sheet wealth management products. This can be credit from trust companies, P2P companies, other non-bank financial institutions. Some of these less traditional areas—so this is an important feature of the China debt problem that we’ve got a very substantial amount of the new debt residing in the shadow sector that is less regulated.

We’ve seen that in many places. It occurred in the US. We saw in Japan. We’ve seen it in Korea. It’s not unique but the size, the fact that $10 trillion US dollars has come from non-traditional sources is a unique issue and is going to present a unique issue to the authorities in terms of how they ultimately deal with this.

Cindy Li:

Can you elaborate in terms of shadow banking and the role it’s playing for the benefit of the audience, what are the risks associated with shadow banking? Is shadow lending following a different pattern than traditional bank lending? How does shadow banking fit into all of this?

Charlene Chu:

There’s two types of shadow credit in China and this can be a very complicated topic so we try to distill this in very simple terms for people. There’s two types of shadow credit in China. One is related to something that domestically within China is referred to as bank channel business and that is effectively banks hiding credit either in their own hidden second balance sheet of off-balance sheet wealth management products or they park that credit with non-banks. That is one type of shadow credit.

The other type of shadow credit is real, informal, new type of lending platforms. This could be P2P, this could be trust companies, leasing companies, factoring companies, all of those types of entities would form the second category. The larger share of shadow credit is that channel business of Chinese banks which is effectively hiding things. It is this nature of the shadow credit. That is we have credit that is being intentionally pushed into hidden channels outside the purview of auditors and outside the purview of regulators that makes this so risky.

It would be one thing if this was all really this second form of shadow credit which is just a bunch of new financial institutions out there doing their thing. That I actually think would be a bit easier to manage because the loss burden from the people who are funding that I think would be clearer and it would be easier for the authorities to impose losses on those entities. In this former type of shadow credit we are in this gray area where a lot of people who are involved in this or actively engaged because they ultimately think that the banks will pay for all the losses if we ever have problems. That is why debt has been growing at the rates it has but it also leaves this unrecognized implicit burden of losses in the future.

Cindy Li:

It seems like the high level of debt both of bank debt and shadow credit that is reflective of China’s financial systems structure. There are a lot of savings channeled through the banking system to finance economic activities. As you mentioned in recent years shadow banking and bond market are playing a bigger role but equity financing is still not functioning as well as we would like them to be. Looking at the financial system, what are some of the potential structural changes that could lead to less reliance on debt for China?

Charlene Chu:

I think we need to take a step back when we think about how could we change this picture and we need to ask ourselves what is the real problem here? What is the underlying issue that we have that has gotten us to this point? I really think it comes down to two things. One is the authorities’ addiction and I would call it an addiction to very high rates of economic growth that are beyond what demand in the economy can support. The only way to fill this gap is with credit.

We then need to ask ourselves why is there such a strong emphasis on very high rates of GDP growth in China and that ultimately comes down to the social contract the Chinese Communist Party has with its people which is: We will deliver on economic growth and improve incomes and improve living standards if you accept one party authoritarian rule. We are in this unhealthy dynamic where we have a country that is already very large that has to keep striving for extremely high rates of nominal GDP growth and the only way to do that is through credit.

When we then say what structural changes do we need to see, an improvement in this dynamic I think on the top of the list has to be we’ve got to break that dynamic. We have got to see the authorities stop trying to obtain these overly high rates of GDP growth that require inordinate amounts of credit that put strain on debt servicing across the economy and financial institutions, all of that. I think we would also want to see much more effort to put zombie companies out of business.

I think one of the reasons why we have seen the pace of credit outstripping the pace of GDP growth is because we have so many zombie companies in China that just need to be kept alive and they’re not necessarily producing more than they were last year, but they need more credit to keep meeting all of their obligations this year. We wind up in this dynamic where more and more money is going to support this very unproductive part of the economy and ultimately I think those companies need to be put out of business or rationalized, consolidated so that we have much more efficiency going on there than what we’ve got at the moment.

The last thing I would say is seeing an acknowledgement of the bad debt that has built up in the financial sector. I think one of the side effects of this climate where the authorities do not tolerate very high NPL ratios, particularly of the larger banks because they’re worried about confidence deteriorating. One of the side effects that is that we wind up just allowing a tremendous amount of bad debt to just keep accumulating in the system and not getting it purged at the rate it should.

Oftentimes those exposures need to have interest capitalized and rolled and so the amount keeps growing every year. I think cleansing that out would also help the economy reset at a level where it did not need to see quite as much credit. I think I did say that was the last point but I would just add something on the currency which is not necessarily part of this problem because we don’t have a large amount of offshore debt but it is one of the macroeconomic vulnerabilities in this story in China. The fact that we’ve got a very heavily managed exchange rate, the economy has capital control and yet it is still very vulnerable to outflows. I think seeing more flexibility in that exchange rate over the longer term is very important to maintaining macroeconomic stability and therefore financial stability.

Cindy Li:

We all know that a healthy economy needs the healthy flows of credit to support growth and China seems to be facing a dilemma between economic growth and financial stability. In that sense given China’s very bank-centered financial system, is the high level of debt an necessary evil in order to support growth and for China to escape the so-called ‘middle income trap.’

Charlene Chu:

I think it’s the bargain that they keep making repeatedly and they’re actually making as we speak at the moment which is we get into these periods, so 2009 and 2015, ’16 are good examples where we see this huge increase in the credit impulse. That leads to much stronger economic growth and a return of inflation which is very helpful in this situation. That dynamic leads to about one to two years of a stabilization in the credit-to-GDP ratio at least to much healthier levels. Oftentimes it’s still increasing but at a much lower rate.

In that type of climate we then start to see the authorities talking about, “Oh we’ve got a debt problem. We’ve got to deal with it. We need to de-risk financial institutions.” This is effectively the dynamic we’ve been in over the last two years but the reality is that commitment to deleveraging and dealing with debt problems only occurs when economic growth is very strong. As soon as it starts to deteriorate as it is as we speak, they immediately move into stimulus mode because there is no tolerance for a significant sacrificing of growth.

This is where I think they go back and forth on this but ultimately they always demonstrate the growth is more important than financial sectors’ stability and health and they’re always willing to make that bargain as they are now.

Cindy Li:

Let’s talk about deleveraging for a moment. I think if you look at total debt-to-GDP ratio as well as corporate debt-to- GDP ratio in 2017 we saw some mild decline in debt-to-GDP ratios. What’s your take on China’s deleveraging efforts so far? Do you think they have been effective? Are decision makers assessing and addressing the problems appropriately?

Charlene Chu:

One of the key issues that I think is going to be very apparent in China if we ever really do wind up in a financial crisis situation is going to be a very broad and serious recognition of the deficiencies in the official data and the wrong signals that it is sending. Most of the markets and almost all of the media for the last 18 months has been writing about a deleveraging narrative and the idea that China has found some way miracle path to grow GDP with significantly less credit, deal with high risks in the financial sector all painlessly.

Our data on credit was showing throughout January through September we were seeing almost the same flow of credit as we saw in 2016 and that is universally believed to have been a year that was off the charts. Our data was basically and we kept telling clients this, our data is saying there is zero deleveraging happening. When we did finally start to see it happen it was in Q4 and it has just plummeted this year. We are now on our data back to a flow of credit that is back to 2007 pre-global crisis levels as a percent of GDP. The Chinese economy has not lived on this little credit more than a decade.

I can see why the authorities are nervous and have gotten into stimulus mode but I think there has been way too much credit given to them in their deleveraging for over the last year because we really didn’t see it happening until late last year, early this year and six months later we’re in stimulus mode. Clearly there’s no real tolerance for the pain that comes with addressing these problems.

Paul Tierno:

Then from your perspective, what would you need to see in order for China to achieve a “beautiful deleveraging?”

Charlene Chu:

I guess what I would say is I don’t know that beautiful deleveraging is even possible. It implies that there is a painless exit to this problem and I am of the view that that is not possible. It does not mean that this has to end in a financial crisis. A crisis by no means is preordained here but the idea that China can somehow painlessly exit these problems within the next 10 years I think is just ridiculous. We only continue to see these numbers going higher and the situation getting worse. There has to be some pain involved and that’s where I was saying I think we need to see a change in view of the authorities in terms of what is the real sustainable level of growth that we can handle in this economy without relying on huge amounts of excess credit.

I think that would be a very important thing we’d need to see. We would need to see an acknowledgement of the bad debt in the system putting zombie companies out of business and all of that I think is very critical to us having confidence that we’ve actually are in a different, healthier dynamic than we’ve been in over the last 10 years. I just don’t see any of that happening any time soon because they’re back in stimulus mode now. All of these deleveraging efforts have to give in this climate.

Cindy Li:

We have talked a lot about debt-to-GDP ratio but that’s only one measure of leverage. You mentioned nominal debt. That’s another measure but if you look at the national balance sheet China also has significant national savings. Do you think those will become the mitigating factor against the potential debt crisis?

Charlene Chu:

They do have a lot of savings but what I would say to that is almost every country that has had a credit crisis has a substantial amount of deposits. There is for some reason this idea that, “Oh we can just net these two things out and what is the real net debt position of the country.” Arguably if we go back to the 1990s in China when everything was government directed on the lending side and when it was almost an entirely state-owned enterprise driven economy you probably could do that type of netting out. But we are not in that situation in China anymore so that type of thing I think doesn’t work. That’s one aspect of the savings issue.

The other aspect is a lot of people think that, “Well, how unhealthy can this situation really be because ultimately this is a high savings rate country and as long as there’s this infinite pool of savings then we always have an infinite pool of funding for new credit extension by banks and other entities.” The reality is particularly since 2015 we have moved into a situation where on an annual flow basis the flow of new credit is about five trillion lending less than new deposits. The good news is that China had a ton of excess deposits that they had built up over the years and they’ve been able to gradually dig into those but we are now starting to get to the point where those are dwindling. We are in a situation where the new national savings is not sufficient to fund the new credit needs if we’re going to remain in this dynamic of trying to achieve unsustainable rates of GDP growth and using credit to get there.

I think many people who know we’ve got a debt situation in China and who believe, “Well look, maybe some day there’ll be a problem but it’s not going to happen in the next two to three years.” I think most people will acknowledge that there have to be some constraints on the idea that a $9 trillion US dollar banking system can be $39 trillion US dollars 9-1/2 years later and another $30 trillion US dollars within another seven years there have to be constraints on that and one of those constraints I think has to be on the funding side. We are already starting to see the signs that the savings is not sufficient for this situation and that should ultimately start to put a cap on how much we can continue to see credit growth at these unsustainable levels.

Cindy Li:

To further elaborate what are some of the changes you would like to see happening in the Chinese economy that would facilitate the reduction of debt?

Charlene Chu:

In addition to what I was saying about just really trying to deal with the corporate sector problems and the zombie company issue we have which clearly is something that is just requiring more and more resources every year, I think there are things related to the functioning of the financial sector that are very important to deal with. One is the price of credit. We are still in a climate where most on balance sheet credit of banks is priced off of benchmark lending and deposit rates set by the PBOC as opposed to risk determined interest rates off of market benchmarks.

I think that type of risk pricing is very important because we simply are not getting the right pricing of the levels of credit that we’re seeing in terms of the amount that’s being extended. I do think we need to see some sort of liberalization there. I think one of the things that has been perhaps the most disturbing development over the last 10 years has been the permission that the regulators have given to Chinese banks to carry a hidden second balance sheet of off balance sheet wealth management products. Allowing a bank anywhere in the world to carry a substantial hidden second balance sheet undermines the integrity of that formal balance sheet. I think we must see a situation where they shut that down effectively.

We have new rules in recent months where the authorities have tried to address this situation but rather than saying, “Okay, you know what? We’re going to shut this down and you need to reincorporate everything.” They have actually gone the exact opposite direction which is, “You can keep everything off balance sheets and as long as you are growing that in alignment with the national interest you can grow that quite aggressively.” We haven’t really seen the reforms there that we need to give integrity to the formal balance sheet.

The last thing I would say is just getting more involvement of regulators in the non-bank space and auditors also. We just don’t have enough oversight and financial reporting of these non-bank financial institutions to really know what is going on and being able to monitor that. I think that is a very important thing that needs to change also.

Cindy Li:

The recent merger of the banking regulator and the insurance regulator into the CBIRC and the recent regulation regarding wealth management products that kind of establish a framework for all kinds of wealth management products, not just bank-issued products. Do you think that’s one step towards reducing regulatory arbitrage?

Charlene Chu:

I think the merging of the bank and insurance regulators does help because to the extent we’ve got credit extension and bank channel business of parking assets with non-banks that are regulated by other regulators certainly merging these entities does help. The old CBRC was responsible for regulation of trust companies so they joined up units. CBIRC is responsible for banks, insurers and trusts. Those are the three largest parts of the financial sector. I think it does give them a better framework there for less arbitraging between the institutions.

Where I think there is still disappointment from my perspective is on the asset management world. Really I think this ultimately comes down to a very different perception of what is an off-balance sheet wealth management product by me versus what it represents to the authorities. To me it is a hidden second balance sheet that is $30 trillion renminbi in size. It is as big as 30-40% of on-balance liabilities of some banks in the country that is very substantial.

If you told any big international bank around the world, “Hey, we’re going to allow you to have a hidden second balance sheet equal to a third of the size of your on-balance sheet,” can you imagine what flexibility that would give them to massage their data and do all sorts of things out of the purview of everyone. The disappointment I have is that the authorities don’t view it that way. I think they view wealth management products as financial innovation and this is a way of giving investors a higher rate of return above a deposit but the reality is the bank uses it as a hidden second balance sheet and these new asset management rules sanction that and that I think is a very unhealthy dynamic here. And it, in my view, is just ultimately is going to lead to ongoing questions about what is the real health of the banks when you know they’re carrying all of this stuff in the hidden second balance sheet.

Paul Tierno:

Charlene, I wanted to get back to one of your comments regarding the composition of the debt specifically regarding credit to the real estate sector. One of the arguments defending credit to real estate or to that sector is that it’s still a young market and compared to some other emerging markets it’s relatively undervalued. Is some of this credit just reflective of a market looking for an equilibrium?

Charlene Chu:

Property is tricky in China and I will certainly tell you that I am not a property expert and so I don’t really know the inner workings of that sector in the way I do with banks and broader financial system. I’ve been watching this for a very long time and I think the key to the property sector holding up ultimately rests on the health of the financial sector. If you look back at many other countries that have run into real estate problems what usually happens is there’s too much credit given to developers, too much credit given to households through mortgages and then we start to get in a situation where we see interest rates rising and people can’t repay it. We have an asset quality problem and then the banks start pulling back.

It is a borrower driven problem that creates a banking sector problem. From observing this for many, many years at this point I have begun to think this is going to play out in China as the reverse. The real estate sector will hold up and it is a very different story depending on where you’re talking about in China; it is a very local story. But I think real estate will hold up as long as the financial sector is able to continue extending very large amounts of credit and rolling all of these outstanding real estate obligations. As long as property developers are not confronted with “you actually need to repay a lot of your debt within the next couple of years,” as long as they don’t face that situation we don’t need to see price declines and those types of things that would actually trigger stress.

It does lead to a bit more of the stable climate than you would think for a country that has just seen a massive real estate boom. In terms of your question about is it still young, I think it is in many ways. I think one thing that China can do if we do wind up in a real estate problem that may not necessarily have been an option in other countries is knock down old supply. We’ve got a lot of low quality old residential and commercial real estate in many locations in China that could really just bulldozed and they can tighten the supply in that way if they really need to.

I think there’s things they can do. It is a young market but ultimately real estate everywhere around the world is a very local story. You’ll have instances where the prices are way out of alignment, too high, and other places where it’s totally fine and that’s the same thing in China.

Paul Tierno:

Great. Finally, people always talk about this situation being unique and that this time it’s different. But we also get a sense of deja vu when we look at countries with high levels of debt. Can China learn from countries that have been in this situation before or is it truly unique?

Charlene Chu:

There’s definitely some unique features and I think the most unique feature to the China story which is what gives much of the market so much confidence is that the Chinese Communist Party is at the helm. The Communist Party has done a very good job since the 80s of shepherding the growth and development of the Chinese economy and they’ve lifted hundreds of millions of people out of poverty in a tremendously short amount of time. They’ve done an excellent job of that.

The Communist Party also has significant influence over the behavior of lenders and borrowers and that is a very different dynamic than we’ve seen in many other countries. We don’t necessarily have totally independent decision making by institutions like we do, for example, in the US. In the US in 2008 we had some bank saying, “Look, by our analysis Lehman is looking very sketchy and we are pulling back lines.” That type of thing in China doesn’t really happen and if it did start to happen on a broad basis they would simply call everyone into a room and say, “You can’t do this. We will all fall together if we do this. We can’t behave that way.”

That type of thing I think does make the Chinese situation different and it does make it more stable than in many other countries. But ultimately I don’t think we can escape the longer-term constraints of are we really going to have enough savings to fund this type of credit indefinitely? Are we going to continue to have a situation where we can have a heavily managed exchange rate and $3 trillion US dollars in reserves trying to defend that when you’ve got tens of trillions of US dollars being added to banking sector assets every decade. Those types of things are very big questions and the pillars of stability are eroding so the savings strength is eroding. The fortress levels of the balance of payments are now down to deficit territory in the first half.

We’re looking at an erosion of some of these strengths and in this type of climate I do think it’s important for the Chinese authorities to look at other examples around the world and see what was learned in those situations and I would hope that they would start acting a little more proactively to address some of these problems. But at this point, certainly the change in policy since July of this year we are clearly back in easing mode. That effectively means more credit extension. This type of let’s deal with of all these credit problems is effectively off the table at the moment.

Paul Tierno:

Well great. Thank you, Charlene. This has been great discussion and we really appreciate your time.

Cindy Li:

Thank you Charlene.

Charlene Chu:

Sure. Thank you for having me.

Cindy Li:

We hope you enjoyed today’s conversation with Charlene. This subject is a complicated issue to cover, even in two episodes. But we hope that insights from our guests have given you some food for thought.

Paul Tierno:

For more episodes like this, you can find us on iTunes, Google Play, and Stitcher. If you like what you hear, please leave a review. Feedback from listeners like you will help more people find us. And for even more content, look up our Pacific Exchange blog available at Thanks for joining us.

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