ZAMBIA: Windfall Tax Controversy – A Critical Analysis
Dr. Kaela B Mulenga
It is nice to feel that one comes from a country like Zambia which is blessed with abundant natural resources and minerals like copper (cu), cobalt, uranium and others. But the celebratory mood soon dissipates when especially one looks at the situation in the long run – for these resources can get exhausted.
Take copper for instance, this is not only a waste resource, but since it is finite, at some point later, it will therefore be exhausted. What happens then? As one politician lamented, once all the profitable minerals are taken out all we’ll have left with will be “big holes” in the ground. Some estimates put our love affair with copper to end in 50 years. That means my 7 year old granddaughter will only be 57 years old then. What will she live on there after?
This situation is compounded because while copper life is going good, currently hardly any savings are being made for neither a rainy day nor any substantial investments; are being undertaken to diversify our economic activities away from copper. When debating on windfall taxes – Hon Yamfwa Mukanga (Kantanshi Constituency MP) said, “We need something to show to our children when copper is gone that – this is what we built from the copper taxes”.
Today, probably more than 90% of our GDP is generated from copper proceeds. In short, no copper no economic growth and no growth, no reduction in poverty. It is that simple.
And we should not forget about the reprehensible damage caused by mining activities. Environmental degradation always occurs. So while we mine other ills and hazards are also being created. We have heard stories of poisonous gas fumes in Mufulira, contaminated Kafue river, and not to ignore the huge copper waste dump in Nkana. All the bad by-products produce a social cost. But who is going to pay for these costs? These costs are externalities to the producer and are never taken into consideration. Corporate social responsibility is not on the agenda of many companies.
When air is polluted and drinking water is full of toxic effluents and chemicals – our health is compromised. So, even if all the profits from minerals were to be surrendered to us, it would be too late – for everybody would be dead by then.
If the long-term prospects are bleak because of depletion – in the medium to long-term, we’ll also be faced with problems of substitution effects. That is, as the price of copper soars, consumption of this commodity is bound to plateau. Why? In due course, persistently high price would force copper consumer industries in China, India, Japan and elsewhere to look for other cheaper substitutes. All profit making organizations in free enterprise, behave that way. They aim for cutting costs to boost their profits.
As we speak, already copper has lost some market to alternative materials like aluminum and plastics. When the price of expensive nickel fell from $50,000 per tone to below 50 percent more of it got used instead of copper. Hence, the higher the copper price, could eventually outstrip its viability for use in say construction piping.
In addition, architecture, plumbing and other energy efficient methods have impacted copper demand somehow. In China perhaps the largest consumer of copper, they have started using simpler fabricated products for roofing. Plumbers have switched to PVC tubing instead of copper. Simply put, due to inventions and/or new technology, we could one day wake up and find our copper completely obsolete or 100% replaceable.
We should also not ignore the fact that economic growth even in China has began to slow down. Mind you, we don’t even know how much stockpiling Chinese have been doing. We can’t bank our hopes only on the fact that China continues to consume some 65% of all world produced copper to feed its modernization program for electricity and infrastructure expansion.
From experience, we should also know that eventually, the total world demand is bound to fall – along with the price. We can recall that copper prices fell drastically in late 70s/early 80s under Kenneth Kaunda’s rule. Also if we were to take into account the impact of excessive supply on the price from other producers (whose decisions are beyond our control) like: Chile, Mexico, Peru, Russia, DR Congo, and China itself – [if it so wished to influence prices], we can’t be banking on perpetually good copper prices.
In summary – these are some of the issues we should keep in the background I think, when we discuss this sensitive but import matter of windfall taxes.
The Big Debate
In our local media – newspapers, TV, Radios and discussion forums on the internet – especially the social websites: a heated debate is raging on regarding different forms of mineral taxes: royalties, operating profits taxes, and in particular – WINDFALL TAX a form of taxing the revenues. Revenues in this case concerns copper earnings. And the question is: should Zambia levy these revenues, and if so, by how much? Should our concern only be limited to profits?
This serious debate has developed into two distinct camps – one pro and the other against, basically the re-introduction of windfall tax (WT). Unlike LAZ who offer their opinion on important national issues, our EAZ stays silent. I have taken liberty to offer my own opinion.
The sharpest salvo on WT came from the current PF Minister of Finance – Hon Alexander Bwalya Chikwanda (ABC or Alex), who has labeled those seeking the re-introduction of the 25% windfall tax as “lunatics”. [The Post, March 22, 2012]. Alex thinks that production costs – including sea and inland costs are already enough burdens on producers. As such, then we shouldn’t levy them more – apart from the merger 6 per cent royalties he proposed in the budget.
This position is probably not shared by some of the PF “back bench” or “freshmen ones”, especially those who faced the youth and miners in the campaign like Hon Wylbur Simuusa (Nchanga Constituency MP)
As one might expect, the sharpest response to counter this, comes from none other than the former Minister of Finance under Pres. Patrick Levy Mwanawasa (Levy) – Ng’andu Magande. Curiously both men happen to be economists. Magande who by the way first proposed windfall taxes sharply argues that: Windfall Taxes are a must if Zambia is to raise sufficient revenue – while the going is good with copper prices for investments and the diversification program. He adds that – “moreover PF was propped into power on the promise of re-introducing the very WTax”. [The Post, March 23, 2012]. So why chicken out now, he asks?
In addition Magande strongly feels that, re-introducing WTax now would be a good policy direction – without which otherwise the investors’ confidence would be affected. He further feels that, flip flopping on WT question puts pressure on the Zambian Kwacha.
A third force in this discussion comes from the previous MMD government people – best represented by ex Minister of Finance – Hon. Dr Situmbeko Musokotwane. Without explicitly saying whether he is for windfall tax or not, Musokotwane however charges that – so long as PF government fails to immediately re-instate the WT as they promised during the September campaign, getting to power would be seen as by “false pretences”. [The Post, December 7, 2011].
Under Pres Rupiah Banda (RB), Musokotwane was the strongest voice fighting against the re-introduction of windfall tax, even if many people still remained skeptical. In fact, there are many Zambians who accused both Musokotwane and RB as being unpatriotic sons for opposing the windfall tax. The inspiration for what I call “RB/Musokotwane doctrine” was based on the premise that – China would continue propping up Zambia financially, hence, sources of budget money was secure.
Along these lines – i.e. being either in favor of or against WT, let me now discuss some main themes I see pertain to either side. For those seeking more details, there is a robust debate on this topic on Zambian Economist. [see www. zambian-economist.com]. About a year or two ago, Chola Mukanga (Cho) – founder of Zambian Economist, presented an excellent discussion on WT in an essay form headed: Eight Reasons for Rejecting Higher Mineral Taxes. Cho discussed in detail pros and cons for each reason.
My attempt here is therefore not to repeat that discussion but just to draw distinct boundaries between those who support the re-introduction of WT and those who don’t. A foundation we shall fall back on later when I go through the economic analysis.
Among the arguments raised by those who are against higher taxes (the Musokotwane group) – increasing windfall taxes, include:-
- This camp contends that there is no investor who could risk their capital if at all they cannot expect good returns. By extension, this group therefore sees low taxation as a strong incentive for attracting more investments.
- They argue that unless you have favorable tax holidays, concessions, and exemption or low both royalties and windfall taxes, you cannot expect to attract foreign direct investments (FDI). [The assumption here being that the bulk of investments would have to come from outside].
- Regarding the viability of taxes, Prof Clive Chirwa, a presidential aspirant (Bolton University) – [see Zambian Economist, Nov, 2010], observed that: “good investors with a heart will accept tax of eight per cent on royalty and 25 percent on windfall tax”.
- But this group believes that if the PF government re-introduces a 25% windfall tax that would be scaring away new investors.
- In cases where agreements and other concessions have been signed between the Zambian government and the mining investors – those should not be broken, terminated or tampered with. Doing so would not only be regarded as violation of ‘Rule of Law’, but would be sending a bad signal to the investors. According to this view, the rule of law means respecting international agreements, which are legal contacts. These must remain binding no matter what.
- This side also opines that – reviewing, renegotiating the contracts and worse still, unilateral cancellation of these agreements is inimical. That can only happen at the peril of destroying investor confidence. Never mind that Zambia is a sovereign country with security concerns of its own. To them, investor long-term stability is more important than what is in Zambians’ interest.
- Rather than taxing mining operations to death, this side prefers designing/inventing other non-mining sources of government revenue. But having a country which is so skewed towards mining, with virtually no other viable alternatives, does that bother them? Yet the perceived alternatives – agriculture and tourism, are still in the development stages. The manufacturing sector initiated during KK’s days, is also almost non-existent. Since there is also this notion that, if you heavily tax private corporations you impede economic development, raising revenue from firms is not an option either. And above all, in Zambia, only a small number of the population has personal incomes you can tax (miners and civil servants).
- Further, you cannot count on collecting any taxes from the grey (cottage) industries either. And when it comes to excise taxes – i.e. from custom duties and tariffs, the larger portion of this would come from imported vehicles. But to encourage the importation of goods promotes externalization of a valuable hard currency to car manufacturers. In short where would the government get large enough revenues if not from minerals?
- It is also important to note that when the opponents of windfall taxes and MMD accuse PF government of not having a common voice on WT and co-ordinated economic policy as Musokotwane charges – they are simply playing politics. They want to use the pretext of WT as a tool to politically weaken PF. In another sense, appearing to oppose WT is a good strategy for them – by first appeasing the investor community and second, by confusing PF members some of whom also oppose windfall taxes.
When we switch sides to those who favor windfall taxes, you have many voices. Magande has turned out to be the staunchest critic of anti-WT group.
- Perhaps the most sound argument raised by this group is that – since copper is exhaustible, unless we use it prudently now when commodity prices are good, we’ll regret later. And so, while the going is good, we must make sufficient revenue from it so that may be, we can diversify to other areas in our economy.
- Andrew Sardanis, the brain child behind both Indeco Ltd & ZIMCO (Zambia Industrial and Mining Company) – therefore he knows a thing or two about international business, said that : “it is an injustice for the Zambian government to only collect US$77.6 million from copper exports valued at US$2.9 billion”. [see Zambian Economist, Oct, 2011].
- If we are to reduce poverty and youth unemployment, which are so rampant in Zambia – minerals extraction sector, whose infrastructure is already in place, has the biggest potential for solving some of these problems. Empowering of people can only occur through creation of jobs.
- The advice coming out of this group to PF government is that – since the request of re- introducing windfall tax was posed to the Zambian people during the elections and that it was massively endorsed by them, negating on it, is breaching peoples wish. Mine Workers Union of Zambia (MUZ), has for example, been openly urging PF government to implement WT without delay. [The Post, December 1, 2011].Otherwise they warn that – the political fortunes of PF party can be lost by this one issue.
- This w-tax side also observes convincingly that – since the copper prices have shot to the roof, currently around US$8,000 per tone – [Bloomberg listing puts it at $3.78 per lb], given the production costs of only about US$3.000 per tone, implies that investors are making handsome profits. Must the profits be excessive to maintain the presence of investors, they wonder? As we shall demonstrate later – unless the company is making huge loses, operations ordinarily continue, so long as the expenses for fixed investments are being covered.
- Moreover, the windfall tax proponents feel that – it is not the investors who are opposed to WT per se, but Zambians themselves who, for some strange reasons, are scared to face them. Whether it is the fear of “masters” syndrome or are compromised because of bribes received or rewards promised – no body knows exactly.
- If investors are not technically opposed to windfall taxes, could then the delay in bringing it back depend on incompetence of our bureaucrats or due to unpatriotic or confused political leadership? We wish that someone can unearth this anomaly. Perhaps Dr Musokotwane can share with Zambians battles our negotiators face when they discuss with investors. Citizens are entitled to know the arguments investors make when condemning WTaxes.
- The long-term stability argument raised by anti-WT voices is also not that strong because as far as Zambia is concerned, that should not be an issue since everyone knows that the country is an oasis of peace. In fact Zambia is probably the most stable country in Africa.
- In addition, the pro-WT makes it known that – raising money for capital investments through borrowing and/or from donors, would not be the preferred route. Why not? Yes, it is because when you get heavily indebted to foreign partners (remember HIPC?) – you do not only lose control and eventually sovereignty, the debts keep on piling up exponentially. The interest rates are raised at will by the lenders, bankers or outside capital sources. [This might even include loan sharks and speculators].
- Being swallowed into international debts they contend – has a lot of risks among them being exposed to potential blackmail. Greece is a classic example of what might happen, if we put emphasis on borrowing. Further, those who harbor ideological or philosophical issues would even tell you that – transferring wealth from State/public owners to the private ones is the worse sin one can commit against ordinary and innocent citizens. Besides, this also worsens the gap between the ‘haves’ and the ‘have-nots’, which has been growing for decades.
In summary, although I have expressed the differences between the two opposing stands eloquently – that is not what the ordinary Zambian is looking for. What they need is the convergence of the two sides into one camp – to map out a sound and fair common ground so that a single public policy prescription can be crafted. Squabbling is a sign of immaturity and cannot benefit the ordinary people. Therefore, unless we can come up with some consensus on policies, which can yield substantial economic development – nobody wins.
In the next section, using economic reasoning, I am presenting some ideas which should be considered by both sides. Hopefully, facts will speak louder than mere words.
The Economic Analysis
Let’s begin by considering a simple model in production process. Financial Times and other Business Bulletins, estimate the production of a tone of copper to be around US$3,000. The total cost (TC) to a firm is composed of a portion of fixed costs (FC) and that of variable costs (VC). Where by fixed ones are those costs for doing business which is constant regardless of the level of production or productivity. Rent and fixed capital equipment are good examples. And respectively, variable costs are those which increase as the level of work/production increases. That is, the more copper bars you produce, for ex., the more workers a company would need. These are the basics we must know.
Thus, fixed cost plus variable cost divided by units produced determines (is equal to) the total cost per unit. That is: FC + VC/ UNITS = TC per unit.
Immediately, the picture emerging from this relationship is that – first, total cost (TC) per unit falls as more units are produced. For example, if the fixed cost (FC) for producing a tone of copper is estimated to be $2,000 per tone and respectfully variable cost (VC) is $1,000 per tone – producing say, 500,000 tones, would be at a total cost per unit of $0.006 per tone. But a 700,000 MTones production level drops this per unit total cost to $0.004 per tone. This implies that the higher production level (i.e. the lesser per unit cost), results in greater profits.
Secondly, even if variable costs were to go up, so long as a higher production level is also being achieved, profitability would still be maintained. Consider another example – if variable cost go up from $1,000 to $1,500 per tone – the per unit total cost for 500, 000 tones, would be $0.007 per tone – while as a 700,000 MTones level reduces it further down to $0.005 per tone.
Now to a profit making enterprise, the question of revenue comes in. These firms have to also examine carefully marginal revenue (MR) – which is the additional revenue a firm receives for making and selling an additional unit of output. That is why in perfectly competitive markets – for profit making’s sake, the price of the product is set to be at least equal to its marginal revenue (MR). Where the total revenue (TR) is the price of the product (P) multiplied by the quantity (Q) sold. [i.e., TR = P x Q].
To keep it simple, I do not go into details analyzing how the law of demand impacts the marginal revenue (MR). It is sufficient here only to know that in general, the price determination in the market is influenced by supply and demand forces. Having considered the marginal revenue side, the company then has to relate it to the marginal cost (MC) side.
Where – the marginal cost is the additional cost incurred to make one more unit of output. Thus, companies will continue employing more workers up to the point when the law of diminishing returns sets in. Ordinarily, as you add more units of labour, you should expect to get more output. The limit a company aims for is when any additional worker/labour unit, causes MC to rise, because at that point, the firm begins to react. Otherwise they’d be losing money.
Why is this discussion important you might ask? Yes, we want to know what guides the decision making of profit-making investor firms. So that people can be able to form their own informed opinions. A politician may also be interested in knowing about these dynamics. For instance, when does a corporation decide when to pull out or stop operations? Is it when a firm is losing money or what?
To an economist, not necessarily so. A company may find it cheaper to continue producing even when they are making loses. How come? Take today when the price of copper is very good, over US$8,000 per tone. Assuming the total cost to be around $3,000 (the price being quoted in many news bulletins) – huge profits of $5,000 per tone is being made. [$8,000 – $3,000 = $5,000]. Very lucrative indeed! So the question of anyone pulling out is quite remote.
And since in the case of Zambia there are no barriers to entry – that, there are no regulatory obstacles or licenses being denied – any willing investor is free to come. Therefore, you can be rest assured that more companies will continue flocking to the country, so long as there is still a large cake of profits to be shared. That is the way free enterprise capitalism works. Competition for profits rules.
But suppose the price of copper now dropped to only US$2,500 per tone. Using the same total costs of $3,000 from our example above ($2,000FC + $1,000VC] – this yields a negative profit (loss) of $500. [$2,500 – $3,000 = $ – 500.00]. But note that – even at this low copper price (a loss), companies would still prefer to remain open, because it is better to lose $500 than losing $2,000 which is the fixed cost the company has to incur anyway.
Therefore, so long as the company’s loses are less than $2,000 (the fixed cost) – it makes plenty of business sense to continue. That is, those companies already in operation in Zambia will not close if they can at least continue to recoup those investments made in plants and other equipments. You can take this word to the bank. [And bear in mind that, since re-capitalization or replacement of depreciated equipment is not done yearly, the fixed costs remain unchanged].
The shut-down point to both economists and business CEOs is when total revenue (TR) exactly equals total variable costs (TVC). Or that, as long as a firm’s revenue is sufficient enough to cover all the variable costs and leave something extra towards fixed costs. You DO NOT STOP operations before this situation is violated. You continue to produce so long as MR is greater than or equal to MC. This is standard operating procedure for firms running profitable businesses.
There are more elegant ways to illustrate this shut-down point, such as through elaborate mathematical equations, but I leave that for another day.
Let me now discuss issues related to deplete table resources, and describe how windfall taxes come into play. A non-renewable resource such as land or minerals – at least in the long-term, is fixed. That is, regardless of price offered for it, you cannot get more of it. Once used up completely, that is it. It is gone! For economists, anything whose supply is fixed – has a supply curve (S) which is perfectly inelastic. A change in price does not change supply]. Therefore vertical as illustrated by line SS in Fig 1.
But as demand of this type of a resource increases – its demand curve (D) illustrated by line (DD) shifts right. This again is easily illustrated in Fig 1 – as demand rises, the price of say land (its rent) shifts up (increases) from P2 to P3. The practical example is that – when the demand for land for say growing food such as maize goes up, it means that the price of having or using that land also rises. That means then that, the higher the prices on say mealie meal leads to more land being used or cultivated for growing that maize.
More specifically, if the price of pieces of land or plots down town rises, makes the owners of that land instant millionaires. If property rights were reviewed and zoning done in compounds like Kanyama and Chawama – if these truly become part of down town Lusaka say, those people owning those plots could become rich. But since these people are relegated to being squatters, they continue to remain as paupers. Transpose this in Zambia as a whole; you get a sense of how our mineral resources are being treated.
From diagram one, we can also see that – initially when the demand for land is very low (at D1D1), land would be free (at q1) since the demand is less than supply. At a low demand, everyone can have any land he/she wants because supply is plentiful. Many people in rural areas survive because of this economic principle. But as demand rises to D2D2, land begins to get scarcer and its price (P2) – rent, gets higher. And similarly, when that demand shoots up to D3D3, its rent (price) – rises yet more to P3.
Note then that: considering Zambia as a whole, due to fixity of supply, the price of our natural resources can shoot to infinity, but you cannot say create more land. What you have just gets used up (exhausted). That is why land or any other non-renewable resource, is considered priceless. This is the way we should be looking at our mineral resources.
As we scrutinize our resources more, we discover that – in the short and intermediate period, land or minerals, which in true reality are FIXED, can be assumed to have upward-sloping supply curves (not vertical as we saw earlier). Demand curve (DD) is as usual, downward slopping. How come? Yes, it is because, in practice and everyday mining operation – the supply curve of say copper (or oil) production looks that way. It appears that way because when it is more difficult to recover or extract these resources from the ground – using advanced technology and modern equipment; you get more output as you go along. This gives an impression as if resources are unlimited. In that sense then, supply is upward (increasing) from a presumably fixed-supply resource. This assumption of an upward-sloping supply curve is demonstrated in Fig 2.
What we observe from this graph is that – as demand raises (from D1 to D2), a shift outward, the economic rent (or land rent) goes up. What does this tell you? It suggests clearly that as the demand for a non-renewable resource increases, naturally its economic also rises.
It is this economic rent which is of interest to our discussion on windfall taxes. The higher the economic rent (or simply land rent); of course, the better it is or should be for the land holders (or owners of resources). Where these resources are publicly owned, it’s the government which becomes their custodian. Then the objective here is to get as much of this rent as possible. Those who propose the 50/50 sharing principle when it comes to sharing of mineral wealth should therefore weigh their demands armed with this reasoning.
The last economic analysis I have is this: assume that Zambia discovers a large pool of oil or gas in Luangwa valley. As stated earlier, oil being another good example of a non-renewable resource – has similar characteristics. Rent generated in the market for oil is illustrated in Fig 3.
As explained above, we have to assume an upward-slopping supply curve (SS) for oil with downward slopping demand curve (DD). Where supply curve (SS) and demand curve (DD) cross (intersect) each other (point E) – determines the equilibrium price and quantity. The equilibrium being the ultimate position of neutrality – once reached, no other strategies or adjustments make economic sense.
At equilibrium, the shaded area (PEPe) on the left side of the supply curve (SS) represents the producer surplus or rent for oil. To capture this rent or portion of it thereof is what government attempts to do by charging the oil companies – royalties or some other form of taxes on profits. Ignoring collection of this surplus would not make any economic sense. It would simply be a loss of revenue to the government.
Therefore, what are some of the conclusions we can draw from this long discussion above? I hope that in some way, we can use it to settle the controversies surrounding windfall taxes, royalties, and other mineral taxes. From my discussion, few things should be clear: –
- Zambians sitting on huge mineral resources ought to find a way of rewarding themselves something from that ownership.
- That, while investors are welcome, they should be seen to pay a fair share for using (renting) these resources belonging to Zambia. Therefore, so long as the sharing is fair, there should be no problem.
- That, it is up to Zambians to know what it is entitled to and claim it accordingly. If they don’t, they will have nobody to blame. Information and economic methodologies exist which Zambia can use for bargaining.
- But as corruption grew in the country and Zambians’ discipline on public policy enforcement got weakened – investors got emboldened. They became adamant and cared little about transparency. No wonder there have been cases of some of them even refusing to pay taxes, Imagine! Where are compliance officials and the judicial system to supervise enforcement?
- In order to settle disagreements on windfall taxes and other mineral taxes or concessions, we need what some people refer to as: “full buy-in” and a transparent “all-party” tax policy. A consensus position which must be presented to the investors.
- We cannot continue with a situation whereby investors are basically defrauding Zambians. And since the world is getting more complicated and unfriendly, we must find nationals who are not only smart, and technically savvy individuals but courageous enough to face exploitive investors. The Zambian people are counting on Pres Michael Sata’s PF government – whose rhetoric so far is at least very encouraging.
- As we saw in the analysis above, as demand for copper (our resources) grows, the rate of extraction also grows – encouraged by good prices. If Zambia does not take advantage of this opportunity – then the allocative effect of that is that – more wealth will be shipped out of Zambia to other already richer countries.
- Conversely, when poor prices set in – this will slow down extraction and therefore economic benefits accruing to us. Even the small revenue we get would disappear. Once more the country would be in a more difficult situation, depending on economic aid and donations.
- In my discussion, there was an insinuation that – given a corruption-free environment, the discussion on windfall tax would not be as controversial. For, no normal profit making firm would find the Zambian conditions – including paying of WTax unfavorable. The super high copper prices of today should encourage even more companies to invest in Zambia.
- If Zambia hesitates or makes a bad decision on this important question of windfall taxes, which shall we blame – is it “kindness”, “ignorance” or “fear” factor? Although Standard & Poors has awarded a B+ grading for Zambia’s current future outlooks, Fitch a short while ago downgraded its Bonds. Some of these are nothing but scare tactics to be watched.
- With US$8 – 10,000 per tone copper price, handled properly should for once, give us the power of the purse. In high prices ought to lie our strength at the negotiation table. If we relent, we’ll again let opportunity pass us by and revert back to our customary position of taking dictations. Must we always succumb to manipulation by others? Why can’t we be the manipulators?
- Finally, because of the fact that minerals are exhaustible, charging a reasonable amount of taxes today, for a rainy day, should be understandable. Revenue is needed now so that the country can diversify and prepare for the day of reckoning (Armageddon) – which will for sure eventually arrive.
Therefore, it is no longer wise to allow investors to invade Zambia and let them exploit its resources at will. We must do something about it. Feedback or comments are welcome. Cheers!!!
Kaela B Mulenga
Toronto, April 19th, 2012.
About: Kaela B Mulenga
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