More on the Pro-Note Deal

This post was written by Colm McCarthy

Here’s a few thoughts on aspects of the pro-note deal concluded last week.

The GGB Interest Saving

One of Karl Whelan’s slides at the recent irisheconomy conference sported the title ‘Eurostat and Reality’. The ‘general government’ concept used by Eurostat and consequently employed in the EU Commission’s implementation of budget rules and bail-out programmes has other critics besides Karl. One critic is the IMF.

http://blog-pfm.imf.org/pfmblog/2009/07/consolidation-of-central-bank-operations-into-the-governments-financial-statements-practice-in-selec.html

The Fund argues that, once central banks begin undertaking quasi-fiscal functions, they may as well be consolidated with the fisc. Australia and New Zealand consolidate their central banks into the fiscal accounts. More pertinently the IBRC was not part of general government and NAMA is not either. Since the fisc was and will be on the hazard for both, the same argument applies to them. The fact that these three institutions, the CBI, the IBRC and NAMA are not part of general government has muddied the waters regarding the budget impact of the pro-note deal as John McHale points out in his post.

The true cost of the pro-note was the interest paid at the ECB’s MRO, the main re-financing rate, currently 0.75%. This will continue to be the cost when the pro-note passes to the CBI and is replaced with long-dated floaters. Transfers of interest arising from the pro-note and its floating successor between Irish government entities wash out in terms of economic impact. But they do not wash out in terms of the measured GGB deficit as per Eurostat, since these entities are not consolidated into general government.

This is the reason why there is an interest saving to the GGB (in addition to the discontinuation of front-loaded capital payments, which had to be funded but are excluded from GGB spending). Funds were being transferred, at high interest, to the IBRC, an operating subsidy if you will which would revert fully to the DoF eventually as part of the residual net worth (positive or negative) of IBRC. The excess interest was treated by ESA-95 as current spending, even though it was really the Exchequer lending money outside the GGB club to an entity it owned, guaranteed and planned to liquidate six years from now. No such sums will now be paid to NAMA or to any other state entity outside the GGB club. Hey presto, an interest saving of €1 billion. The interest shown, although heading in the right direction, is still not ‘correct’, in the sense that it does not equal the figure that would be shown if the Exchequer’s offspring were all living at home. The figure still looks too high, but by less. The ‘correct’ figure will rise eventually for two reasons: the 0.75% will rise as the Eurozone economy improves, and the amounts borrowed at this favourable rate will decline as the floaters in the CB’s book are re-financed in the market.
There has been no creative accounting and the DoF have done everything by the book. ESA-95 is just not a very coherent book. For more on all of this in an Irish context, see

http://researchrepository.ucd.ie/bitstream/handle/10197/561/mccarthyc_article_pub_005.pdf?sequence=3

The Floaters

The NTMA has already issued to the Central Bank eight long-dated floaters.
The base rate is six-month Euribor, recently a little under 0.4%. The margins over Euribor average about 2.6% so the government has issued €25 billion in very long dated floaters with opening yields of around 3%. The margin is fixed to maturity.

The rate does not matter (neither Euribor nor the margin) until the Central Bank sells some of the bonds and coupons start to leak outside the (fully consolidated) Irish state system. The CBI has agreed a schedule of minimum sales of the floaters, starting at €0.5 billion by end-2014 with steadily rising amounts that will see the lot gone by 2032. This means that the availability of concessionary state finance at the MRO rate contracts from 2014, slowly at first but more rapidly as 2032 approaches. The state is exposed at a diminishing rate to the ECB’s MRO rate and to the margin and Euribor at an increasing rate as the Central Bank sells out. The MRO will doubtless be higher during the life of these bonds, as will Euribor. The margin could compress or blow out. The exposure to this margin would have arisen anyway, and sooner, without the deal, as the pro-notes would have been replaced with market funding sooner. The margins, which are fixed through the life of the notes, have had to be estimated, since long-dated floaters are relatively rare and Ireland has none in issue. The initial margins chosen do not matter – it is the margin when the bonds are sold on that determines the effective cost. Floaters normally trade close to par, but the margin over Euribor for Irish sovereign risk could prove volatile and these bonds, when they come to be dealt in the secondary market, could trade further from par (on either side) than highly-rated sovereign floaters. Over the long haul, floaters are closer to index-linked bonds, since Euribor should follow the inflation rate.

Options in Favour of the CBI

The Central Bank will have some interesting but, it would appear, not very valuable options. Where these are options against the issuer, they have of course no net value to the state. The CB has an apparent option to convert the floaters to fixed, but only with the agreement of the NTMA. This option expires as the bonds pass to market purchasers. Without this provision the NTMA could get stuck with a growing component of long-dated floaters in its debt portfolio, for which market appetite is unknown. The NTMA rather than the CBI will likely call the shots on the exercise of this option – it will really be an option in favour of the NTMA, against the CBI as holder, but not against the ultimate market purchasers.

The CB has the option to sell more than the minimum required, but the MRO would have to exceed Euribor plus about 2.6% for this to be attractive, and would have to look like staying that way. This is most unlikely so this option has negligible value.

An Option in Favour of the ECB?

The CB has agreed (at the behest of the ECB) to a schedule of minimum sales into the market which will see the Central Bank dispose entirely of these securities by 2032, vaporising €25 billion of blameless money along the way. This schedule lengthens the duration of access to funds at the MRO relative to the duration under the pro-notes and is the key benefit of the deal. Any acceleration of this schedule diminishes the value of the deal.

The ECB can seek accelerated sales of the CBI’s holdings of the bonds, curtailing access to low-cost funds. This is potentially a serious option against the state as issuer. Governor Honohan also stated on RTE on Sunday that the CBI had agreed to retire the floaters as quickly as possible. He said: ‘The CBI has undertaken to sell these bonds as soon as possible, subject to financial stability’. This leaves the terms on which the state retains access to low-cost finance unclear. What is ‘financial stability’? Who decides if financial stability prevails, the CBI or the ECB? Is there a written understanding on the criteria that will be used? If so, it would be nice to know what it says. If not, there is a risk of future conflicts here.

30 Responses to “More on the Pro-Note Deal”

  1. OMF Says:

    …….

    Well, that’s about as much as we really know anyway.

  2. colm mccarthy Says:

    Here’s a few thoughts on aspects of the pro-note deal concluded last week.

    The GGB Interest Saving

    One of Karl Whelan’s slides at the recent irisheconomy conference sported the title ‘Eurostat and Reality’. The ‘general government’ concept used by Eurostat and consequently employed in the EU Commission’s implementation of budget rules and bail-out programmes has other critics besides Karl. One critic is the IMF.

    http://blog-pfm.imf.org/pfmblog/2009/07/consolidation-of-central-bank-operations-into-the-governments-financial-statements-practice-in-selec.html

    The Fund argues that, once central banks begin undertaking quasi-fiscal functions, they may as well be consolidated with the fisc. Australia and New Zealand consolidate their central banks into the fiscal accounts. More pertinently the IBRC was not part of general government and NAMA is not either. Since the fisc was and will be on the hazard for both, the same argument applies to them. The fact that these three institutions, the CBI, the IBRC and NAMA are not part of general government has muddied the waters regarding the budget impact of the pro-note deal as John McHale points out in his post.

    The true cost of the pro-note was the interest paid at the ECB’s MRO, the main re-financing rate, currently 0.75%. This will continue to be the cost when the pro-note passes to the CBI and is replaced with long-dated floaters. Transfers of interest arising from the pro-note and its floating successor between Irish government entities wash out in terms of economic impact. But they do not wash out in terms of the measured GGB deficit as per Eurostat, since these entities are not consolidated into general government.

    This is the reason why there is an interest saving to the GGB (in addition to the discontinuation of front-loaded capital payments, which had to be funded but are excluded from GGB spending). Funds were being transferred, at high interest, to the IBRC, an operating subsidy if you will which would revert fully to the DoF eventually as part of the residual net worth (positive or negative) of IBRC. The excess interest was treated by ESA-95 as current spending, even though it was really the Exchequer lending money outside the GGB club to an entity it owned, guaranteed and planned to liquidate six years from now. No such sums will now be paid to NAMA or to any other state entity outside the GGB club. Hey presto, an interest saving of €1 billion. The interest shown, although heading in the right direction, is still not ‘correct’, in the sense that it does not equal the figure that would be shown if the Exchequer’s offspring were all living at home. The figure still looks too high, but by less. The ‘correct’ figure will rise eventually for two reasons: the 0.75% will rise as the Eurozone economy improves, and the amounts borrowed at this favourable rate will decline as the floaters in the CB’s book are re-financed in the market.
    There has been no creative accounting and the DoF have done everything by the book. ESA-95 is just not a very coherent book. For more on all of this in an Irish context, see

    http://researchrepository.ucd.ie/bitstream/handle/10197/561/mccarthyc_article_pub_005.pdf?sequence=3

    The Floaters

    The NTMA has already issued to the Central Bank eight long-dated floaters.
    The base rate is six-month Euribor, recently a little under 0.4%. The margins over Euribor average about 2.6% so the government has issued €25 billion in very long dated floaters with opening yields of around 3%. The margin is fixed to maturity.

    The rate does not matter (neither Euribor nor the margin) until the Central Bank sells some of the bonds and coupons start to leak outside the (fully consolidated) Irish state system. The CBI has agreed a schedule of minimum sales of the floaters, starting at €0.5 billion by end-2014 with steadily rising amounts that will see the lot gone by 2032. This means that the availability of concessionary state finance at the MRO rate contracts from 2014, slowly at first but more rapidly as 2032 approaches. The state is exposed at a diminishing rate to the ECB’s MRO rate and to the margin and Euribor at an increasing rate as the Central Bank sells out. The MRO will doubtless be higher during the life of these bonds, as will Euribor. The margin could compress or blow out. The exposure to this margin would have arisen anyway, and sooner, without the deal, as the pro-notes would have been replaced with market funding sooner. The margins, which are fixed through the life of the notes, have had to be estimated, since long-dated floaters are relatively rare and Ireland has none in issue. The initial margins chosen do not matter – it is the margin when the bonds are sold on that determines the effective cost. Floaters normally trade close to par, but the margin over Euribor for Irish sovereign risk could prove volatile and these bonds, when they come to be dealt in the secondary market, could trade further from par (on either side) than highly-rated sovereign floaters. Over the long haul, floaters are closer to index-linked bonds, since Euribor should follow the inflation rate.

    Options in Favour of the CBI

    The Central Bank will have some interesting but, it would appear, not very valuable options. Where these are options against the issuer, they have of course no net value to the state. The CB has an apparent option to convert the floaters to fixed, but only with the agreement of the NTMA. This option expires as the bonds pass to market purchasers. Without this provision the NTMA could get stuck with a growing component of long-dated floaters in its debt portfolio, for which market appetite is unknown. The NTMA rather than the CBI will likely call the shots on the exercise of this option – it will really be an option in favour of the NTMA, against the CBI as holder, but not against the ultimate market purchasers.

    The CB has the option to sell more than the minimum required, but the MRO would have to exceed Euribor plus about 2.6% for this to be attractive, and would have to look like staying that way. This is most unlikely so this option has negligible value.

    An Option in Favour of the ECB?

    The CB has agreed (at the behest of the ECB) to a schedule of minimum sales into the market which will see the Central Bank dispose entirely of these securities by 2032, vaporising €25 billion of blameless money along the way. This schedule lengthens the duration of access to funds at the MRO relative to the duration under the pro-notes and is the key benefit of the deal. Any acceleration of this schedule diminishes the value of the deal.

    The ECB can seek accelerated sales of the CBI’s holdings of the bonds, curtailing access to low-cost funds. This is potentially a serious option against the state as issuer. Governor Honohan also stated on RTE on Sunday that the CBI had agreed to retire the floaters as quickly as possible. He said: ‘The CBI has undertaken to sell these bonds as soon as possible, subject to financial stability’. This leaves the terms on which the state retains access to low-cost finance unclear. What is ‘financial stability’? Who decides if financial stability prevails, the CBI or the ECB? Is there a written understanding on the criteria that will be used? If so, it would be nice to know what it says. If not, there is a risk of future conflicts here.

  3. colm mccarthy Says:

    Sorry for sequence, the software acting up this end.

  4. OMF Says:

    Any acceleration of this schedule diminishes the value of the deal.

    The ECB can seek accelerated sales of the CBI’s holdings of the bonds, curtailing access to low-cost funds. This is potentially a serious option against the state as issuer.

    …..
    Is there a written understanding on the criteria that will be used? If so, it would be nice to know what it says. If not, there is a risk of future conflicts here.

    Given that the ECB has not offically agreed to the deal, are you saying that this whole procedure can still be nipped in the bud if the Bundesbank decides to object in 3 weeks time?

  5. bazza Says:

    “The ECB can seek accelerated sales of the CBI’s holdings of the bonds,”

    This seems to me to be a very important point. From the calculations I have done, the relative value of this deal is highly sensitive to how long the CBI can hold onto the bonds.

    The fact that the ECB can force the Central Bank to sell the bonds, means that the ECB can unaccountably impose arbitrary costs on the taxpayer. How is it that an unelected body can hold such power over nation states?

  6. Frank Galton Says:

    http://www.independent.ie/opinion/analysis/colm-mccarthy-a-coup-for-the-government-but-it-still-has-unfinished-business-when-it-comes-to-debt-29059259.html

  7. grumpy Says:

    @colm mcc

    “The ECB can seek accelerated sales of the CBI’s holdings of the bonds, curtailing access to low-cost funds. This is potentially a serious option against the state as issuer. Governor Honohan also stated on RTE on Sunday that the CBI had agreed to retire the floaters as quickly as possible. He said: ‘The CBI has undertaken to sell these bonds as soon as possible, subject to financial stability’. This leaves the terms on which the state retains access to low-cost finance unclear. What is ‘financial stability’? Who decides if financial stability prevails, the CBI or the ECB? Is there a written understanding on the criteria that will be used? If so, it would be nice to know what it says. If not, there is a risk of future conflicts here.”

    This stuck out as the important but apparently ignored variable. Honohan also said he thought there was no realistic possibility of the “deal” being revisited or reneged on by the ECB - and I imagine journalists will wrongly take this to mean that the idea the CBI holding period could be shorter than the minimum sales suggest, can be ignored. The fact is this possibility, in fact obligation, is part of the deal.

    Comments on John McH’s thread echo the point about financial stability. Irish gilts could be viewed as on the cusp of financial stability.

    What this phrase means affects the value of the deal significantly.

  8. paul quigley Says:

    Looks like it is monetary financing after all. Or so say the Deutschebank analysts.

    http://www.facebook.com/pages/Edward-Hugh/103632406357698?v=wall

  9. Frank Galton Says:

    Headlines we won’t see, but should –

    “ECB to test for monetary financing horsemeat in Irish prom note burger”

  10. OMF Says:

    I have a suspicion that this deal is about to begin a very slow unravelling.

    The lesson here is that, if you are going to act unilaterally, you had better be prepared to say so openly.

  11. Bryan G Says:

    @Colm McC

    Good article - a couple of questions…

    Floaters normally trade close to par, but the margin over Euribor for Irish sovereign risk could prove volatile and these bonds, when they come to be dealt in the secondary market, could trade further from par (on either side) than highly-rated sovereign floaters

    What will happen if the bonds are not at par when sold - will the profit or loss (compared with the nominal amount of CBI funding to be extinguished on the sale) remain on the CBI’s balance sheet, or would it be ’settled’ on the date of sale, with an extra capital injection (or distribution) between the Exchequer and CBI?

    The CB has the option to sell more than the minimum required, but the MRO would have to exceed Euribor plus about 2.6% for this to be attractive, and would have to look like staying that way. This is most unlikely so this option has negligible value.

    Are there two separate payment streams made by the CBI to the ECB at the MRO rate - one an interest charge on any ELA/CBI funding, and a second due to the Intra-Eurosystem Liabilities incurred as a result of the withdrawal of foreign bank funding, or is there only one? I’ve never been clear whether the ECB loan fee at the MRO rate is just a proxy for the TARGET2 payments, to avoid getting into TARGET2 terminology, or is a second discrete payment stream. If there were two separate payment streams, then selling the bond to Deutsche Bank, for example, would result in a net gain greater than selling to BOI, as the TARGET2 liability payments would be reduced due to the inflow of foreign money.

  12. Joseph Ryan Says:

    “Funds were being transferred, at high interest, to the IBRC, an operating subsidy if you will which would revert fully to the DoF eventually as part of the residual net worth (positive or negative) of IBRC.”

    I would take the view that it is the magic disappearance of ‘operating subsidy’ to IBRC that the DOF have failed to account for in it’s ’savings’ calculation. The requirement for NAMA to replace some, if not most, of the costs currently being paid by IBRC seems to have been disappeared from the calculations. Some, of course, have disappeared, thankfully.

    re: Selling bonds back into the market.
    Financial stability is a Debt/GDP ratio of 60%.
    No more convenient changes of rules by the ECB in this area. We should have learned our lesson on that.

  13. bazza Says:

    @Bryan G

    If the bond sell for below par, then the Govt has to suck it up. In effect, the Yield To Maturity on the bond will be higher than the nominal (floating) coupon.

  14. bazza Says:

    @Bryan G

    I think this point feeds into the one about the timing of the bonds sale. In essence there is a large degree of conditionality attached to the deal.

    If the ECB think we are dragging our feet on the fiscal front we could hypothetically be “punished” by being force to sell bonds below par. This should provide enough incentives to to keep Head Prefect Noonan and his replacements in their places.

  15. Paddy Healy Says:

    Thanks to Colm McCarthy for clearly answering the question which I asked earlier in a comment on an earlier contribution.
    The question was: ““Central Bank expected to hold the government bonds for a weighted average of 15 years ”

    “expected” is very imprecise expression. Expected by whom?
    What authority determines when the bonds must be sold by the Central Bank?
    Precedent is not a reliable guide in unprecedented circumstances.”
    Colm’s answer is: “The CB has agreed (at the behest of the ECB) to a schedule of minimum sales into the market which will see the Central Bank dispose entirely of these securities by 2032, vaporising €25 billion of blameless money along the way. This schedule lengthens the duration of access to funds at the MRO relative to the duration under the pro-notes and is the key benefit of the deal. ANY ACCELERATION OF THIS SCHEDULE DIMINISHES THE VALUE OF THE DEAL.(my emphasis PH)
    The ECB can seek accelerated sales of the CBI’s holdings of the bonds, curtailing access to low-cost funds. This is potentially a serious option against the state as issuer. Governor Honohan also stated on RTE on Sunday that the CBI had agreed to retire the floaters as quickly as possible. ‘The CBI has undertaken to sell these bonds as soon as possible, subject to financial stability’. This leaves the terms on which the state retains access to low-cost finance unclear. What is ‘financial stability’? Who decides if financial stability prevails, the CBI or the ECB? Is there a written understanding on the criteria that will be used? If so, it would be nice to know what it says. If not, there is a risk of future conflicts here.”

    The value of the deal is unknown and can be determined by the ECB!

  16. Brian Woods II Says:

    Colm McCarthy, John McHale and Seamus Coffey all singing from the same hymn sheet, so I guess we have a consensus of the substantive “wins” from the New Deal, and thanks to them for explaining it each in their own convincing way.

    The fiscal aspects remain the more elusive. Any wins on this front which are not backed up by hard core money flows to the Government and all its offspring would seem to a layman like me to be artificial book keeping.

    In the real world outside the fiscal conventions, we expect to make an NPV of 4bn from elongated cheap monetary financing and from the point of view of those thinking of lending to us we have 20bn less to raise in the next 10 years. That about sums it up for me.

  17. Bryan G Says:

    @bazza

    If the bond sell for below par, then the Govt has to suck it up. In effect, the Yield To Maturity on the bond will be higher than the nominal (floating) coupon.

    Agreed, but I was wondering what this means in practice. Central banks can live with losses/negative equity in a way that ordinary banks cannot (e.g. Karl Whelan’s analysis on TARGET2 etc.), so in theory the loss could just sit there until it eventually disappears over time via retained earnings/seigniorage profits. However in practice I imagine the ECB would want the unprinting amount to be the full amount, and the government would borrow to make up the difference, or the CBI would sell more to make up the difference. In the latter case the CBI could run out of bonds and would need to be “topped-up” to meet the obligations towards the end of the 20 years.

  18. Bryan G Says:

    @bazza

    I think this point feeds into the one about the timing of the bonds sale. In essence there is a large degree of conditionality attached to the deal.

    I’d also agree with that. I think it fits well into the principles underlying OMT - money printing with conditions. In practice, of course, it blurs the line between monetary policy and fiscal policy, with the ECB getting involved in the latter.

    I find the phrase “as soon as possible” a very odd one to include in the agreement, and it strikes me as something that was added at the last minute to get Wiedmann on board. I also think a switch to holding the bonds in the trading book rather than the investment book might have been last minute. Newspaper reports have said that there were changes in the terms relating to the CBI’s disposal of the bonds on Thursday morning, before the deal was closed at lunchtime.

  19. colm mccarthy Says:

    Bryan G:

    The treatment of the BoI debt from last year’s manouvre is another candidate for the last-minute change on Thursday morning.

  20. Bryan G Says:

    @Colm McC

    The treatment of the BoI debt from last year’s manouvre is another candidate for the last-minute change on Thursday morning.

    True - though by itself that aspect seems to represent a move in favour of the Irish gov rather than a concession to the Bundesbank to get the deal over the line. For me the misalignments between the statements by the CBI and the DoF (e.g. the former contains “as soon as possible”, and the latter does not) suggests that was the area of last minute changes, with the result that there wasn’t time to sync up all the wording before it became public.

  21. Anonymous Says:

    It was always clear that the CBI would have to sell the bonds as soon as possible. Anything else would be monetary financing and hence prohibited.

    The question of what entails “as soon as possible” is more complicated. What is clear though is that maintainig access to financing at the MRO rate for the Irish public sector is not an admissible justification for delaying sales. I would think that once demand for Irish sovereign bonds recovers sufficiently so that the markets can accommodate bond sales without substantial effect on the market price, it’s time for the CBI to start selling.

    The sales schedule is in the hands of the CBI, but it will be monitored by the ECB as part of its regular monitoring of national central banks’ investment portfolios. If the ECB finds that the CBI is dragging its feet for no legitimate reason, it has the powers to intervene.

  22. Joseph Ryan Says:

    @Anonymous
    “What is clear though is that maintainig access to financing at the MRO rate for the Irish public sector is not an admissible justification for delaying sales.”

    So in summary, an illiquid and ailing bank, of which there is an abundance in Europe, can avail of LTRO at about 1%. But if a State under duress bails out the creditors of a dead bank, they must borrow the money in the market at ~3% for such an operation.

    “If the ECB finds that the CBI is dragging its feet for no legitimate reason, it has the powers to intervene.”

    Lets hope the ECB, before any intervention at the CBI, collects in its 1% LTRO money. About 1bn as I understand it. That seems more equitable to me.

  23. Joseph Ryan Says:

    The above should read 1Trn not 1BN. I am mixing up my trillions with my billions. Its an easy thing to do.

  24. Anonymous Says:

    @Joseph Ryan

    To answer your questions, yes, more or less.

    The Treaty explicitly prohibits central banks from maintainig any kind of credit facility in favour of a sovereign.

    The Treaty also explicitly allows conducting credit operations with credit institutions against adequate collateral.

  25. Brian Woods II Says:

    @ JR/Anonymous

    The apparent inconsistency is not entirely irrational.

    It is obvious why there is a ban on national governments asking their CBs to print money for them, that’s Zimbabwe territory.

    Whereas LTRO is not a fiscal operation but a monetary one.

    I think within the spirit of what was intended in the EZ legislation the Irish government isn’t doing a Zimbabwe though it doesn’t help that we have the worst fiscal deficit in the EZ.

  26. grumpy Says:

    Might be issuing some more Promissory Notes apparently - or having all the bailed out banks sell loads more loans to Nama (if the Nama Act is constitutional, that is).

    http://namawinelake.wordpress.com/2013/02/12/loans-made-by-anglo-in-2009-may-not-be-enforceable-if-the-bank-was-insolvent/

  27. Ciarán O’Hagan Says:

    Excellent post. Helpful. Thanks.

  28. Rob S Says:

    http://www.ntma.ie/news/ntma-issues-eight-new-floating-rate-treasury-bonds-in-exchange-for-promissory-notes/

    Are the margins set by the NTMA on the bonds above fixed? i.e. am I correct in my understanding that only the Euribor component of the overall interest rate can change?

    (Disregarding the MRO for a moment).

  29. colm mccarthy Says:

    Rob S:

    The margins are fixed, but they do not matter in the sense that the payments are from the state to itself until the bonds are sold by the CB What matters is the margin in the market when they are sold (also Euribor when they are sold).

  30. Rob S Says:

    Colm

    Many thanks.

    I thought the margins were based on the bond ’spread’ and thus wondered if they could improved if Irish bond yields improved.

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