San Marino -- 2004 IMF Article IV Consultation, Preliminary Conclusions

May 11, 2004

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.


San Marino—2004 Article IV Consultation
Preliminary Conclusions

May 11, 2004

1. After the exceptional performance of the 1990s, growth has slowed since 2000 and San Marino is now at a critical juncture. It can reform its economy, offset the recent loss of competitive advantages with efficiency gains, and, building on its several strengths, return to the rapid growth of the past. Alternatively, without reforms, the erosion of its competitiveness will continue, vulnerability to external shocks will be heightened, and its growth rates will tend to converge towards those of the neighboring Italian regions. While political instability has delayed the required policy response, the new government is rising to the occasion and has committed to implement an ambitious reform agenda, while actively negotiating an array of international agreements. The under-way strengthening and deepening of the global recovery create a window of opportunity that the authorities should not miss.

2. San Marino is still outperforming its neighbors but, over the period 2000-02, average growth decelerated to 2.7 percent from an average almost three times as high in the 1990s. The economy is likely to have remained sluggish also in 2003. While growth rates still exceeded those recorded in neighboring regions, Italy, and the euro area, they were lower than in other small European countries — such as Ireland, Luxembourg, Andorra, Cyprus, and Monaco — which expanded rapidly even during the global slowdown.

3. In San Marino, both permanent and transitory factors account for the weakening of the economy. Profitability of the main sectors (manufacturing, financial, commerce, and tourism) has dwindled with the fading of key factors that have supported past growth. Lower corporate tax rates in Italy and other EU countries, together with higher taxes on Italian commuters, have trimmed previous tax advantages. Reforms enhancing the flexibility of the Italian labor market have reduced the appeal of investing in San Marino. Moreover, the appreciation of the euro has curbed the competitiveness of manufacturing firms, tax amnesties in Italy (scudi fiscali) have led to the repatriation of considerable funds previously deposited in Sammarinese banks, and languishing Italian consumption has depressed commerce and tourism.

4. Against the backdrop of these developments, the government faces three main challenges. First, it needs to improve its financial position which deteriorated on the heels of a string of budget deficits and devaluations of past tax credits. The 2004 budget is a first important step to correct past imbalances. Addressing long-standing tax administration problems and reforming generous entitlement programs would make it feasible to realize the needed further fiscal adjustment with unchanged or lower tax rates.

5. Second, there is a need to reform labor and product markets. The priority is to eliminate bureaucratic hindrances that stunt business activity and reduce state interventions that distort the allocation of resources. The government has made considerable progress by reining in the public sector wage bill, whose previous large size was a long-standing source of wage drift and loss of competitiveness for the whole economy. We also welcome the government's objective of substituting clear and transparent rules to political discretion in key areas of economic activity ranging from licensing new businesses to authorizing nonresidents' hiring. Much remains to be done, however, by streamlining the bureaucracy, speeding up administrative procedures, and regulating fixed-term labor contracts.

6. Third, the authorities should create the conditions for a further development of the financial sector while safeguarding its soundness. This sector is at a turning point. It might slim down to a level commensurate to the needs of the local economy — as international pressures threaten bank secrecy practices and curtail tax incentives for nonresidents to invest in San Marino. Or, it can reach the size typical of a full-fledged financial center, able to attract substantial funds because of its efficiency, the range of services offered, a modern financial legislation, and a nimble supervisory and regulatory agency ensuring the stability of the system without imposing an excessive burden. In this scenario, the contribution to growth of the financial sector could rise to the level prevailing in other small European financial centers.

7. In the medium term, this three-pronged approach can underpin San Marino's economic performance and bring it back on a high-growth path. The government is aware that San Marino urgently needs to identify new sources of growth to adapt to the changed external environment. The key to success will be to act swiftly and overcome initial reluctance to reform by spelling out its long-term benefits. In the short term, the improved global outlook can lead to a rebound also in San Marino with foreign demand driving the recovery in manufacturing and tourism, and an upward trend in interest rates raising the profitability of the banking system. These positive developments would create the necessary conditions to press forward with reform.

8. Fiscal policy: The government needs a strong financial position to buffer adverse external shocks and output growth volatility. Over the last decade, the net financial position of the central government―excluding the reserves of the pension system―passed from a net asset position of 6 percent of GDP in 1992 to a net liability position of 14.5 percent of GDP in 2003. To finance the cash deficit, the government ran down its deposits with the banking system and, since the mid 1990s, borrowed short-term. Although fiscal adjustment is under way―with Parliament having approved a budget close to balance for 2004 and set balanced-budget targets for 2005-2006, improving the fiscal position on a sustainable basis remains a challenge. While the new government is moving in the right direction by containing expenditures and taking steps that should improve revenue collection, there remains a need to control health and pension expenditure over the medium term.

9. A glaring budget weakness is the poor revenue performance. Lapses in tax collection, long-lasting effects of past legislative initiatives (e.g., widespread tax exemptions), and the recent slowdown in growth are responsible. Higher Italian taxes on commuters' incomes and the likely outcome of the ongoing negotiations with the EU on the savings tax directive―according to which part of the withholding taxes on nonresidents' interest would be remitted to the country of residence of the investor―will put further pressure on tax proceeds.

10. The authorities have reacted to these worrying revenue prospects by eliminating tax exemptions since 2002, changing notification requirements to enhance compliance with property-income tax, and improving estimates of import tax (monofase) reimbursements. To increase revenue collection, new norms limit the scope for accumulating tax arrears and put the central bank in charge of collecting overdue taxes. While we welcome these measures, there is a need to make their application more effective, and to increase incentives to pay taxes, by allowing the tax collection agency to access financial information on non-complying taxpayers.

11. We commend the government and the unions for the responsible wage negotiations, the limited use of overtime, and the hiring freeze in the public sector that have reduced the wage bill in percent of GDP and contained the deficit. Given that average public sector wages remain above those in the private sector and that excess employment was accumulated in the public administration in past years, there is scope for further savings without affecting the quality and level of services to the public.

12. The public health system is a case in point. In recent years, savings on the wage bill of the Istituto di Sicurezza Sociale (ISS) have stabilized health expenditure, and reduced it marginally in percent of GDP, without curtailing public health services. In recent months, the government has also renegotiated price conditions with suppliers, and limited the list of pharmaceutical products offered free of charge to the best-price medicines within each category. Since 2003, the budget provides a fixed allocation to the ISS for health expenditure, after years in which it was almost fully financed with ex-post budget transfers. We support these initiatives and the draft legislation that institutes an Health Authority and specifies professional requirements for health administrators to create the conditions for additional savings. However, given that demand for health services is likely to continue growing at a rapid pace, using only cost reductions to contain transfers to the ISS is a moot strategy and both the government and the general public should realize that it may become necessary to introduce co-payments on selected services and pharmaceutical products in the near future.

13. Pension reform needs to be far-reaching. The reserves of the pension system and past employment growth should not lull the public into a false sense of security. While reserves remain substantial, population aging would endanger the long-term solvency of the system even with current employment growth rates. Moreover, both the prospects of slowing employment growth — associated with commuters' incomes becoming subject to Italy's income tax — and the need to reduce transfers to the ISS in view of declining tax revenues, make pension reform urgent. Parliament has recently approved some limited measures, including higher retirement age for newly-hired workers, and more elevated contribution rates for artisans and shop-owners. The impact of these changes will be small, especially in the short run, and a more substantial reform cannot be further procrastinated. In view of the substantial pension reserves and the still small public debt, San Marino is well placed to introduce a fully-funded system. A key element of any reform is linking pensions to paid social security contributions over the entire working life of an individual as it reduces incentives to underreport incomes and improves the balance of pension funds that have been in deficit for years. In addition, the reform should foresee an automatic increase in the minimum contribution period (or a reduction in annual benefits) with the lengthening of life expectancy. The broad Parliamentary majority makes this the time to implement an equitable and long overdue pension reform. The government can put it over to the public by expounding its fairness and its capacity to ensure the availability of resources for future pension obligations.

14. The authorities are exploring the possibility of placing a debut Eurobond of up to € 120 million (about 10 percent of GDP) and up to ten-year maturity. We support the objective of using the proceeds to retire high-interest bank loans but borrowing an additional amount to finance infrastructure projects is debatable. Until tax compliance problems are solved, even projects that stimulate growth might not generate the tax revenues needed to pay back the new debt. We also encourage the government to verify whether renegotiating the high-interest debt with the banking system would not be a lower-cost alternative.

15. Structural policies: Containing public sector employment and wage growth has not only critically contributed to fiscal adjustment but has also reduced labor market distortions. The government should, however, remove any presumption that the public administration might resume acting as an employer of last resort. This can be achieved through the planned reform of the public administration and by giving managers autonomy in hiring decisions. Public administration reform should also aim at streamlining the bureaucracy and speeding up administrative procedures, thus ensuring that San Marino may continue to lead, and not trail, the public administration of neighboring regions in efficiency. Appropriately-designed welfare programs — rather than forced hires that reduce the efficiency of public enterprises and the central government — should address conditions of need.

16. We commend the approval of the new regulation of nonresidents' hiring as it allows to speed up the procedure while reducing the scope for political interference in the decision. Every effort should be made to avoid that the remaining hiring restrictions may discourage expanding or opening businesses in San Marino, which, in the end, are likely to provide additional job opportunities also to Sammarinese workers by expanding total income. A broad-ranging regulation of fixed-term contracts matching the flexibility offered by Italian "atypical" contracts is also urgent, as it can offset a critical advantage that neighboring regions can offer.

17. We welcome the recent abolition of tax exemptions and we encourage the authorities to make it permanent, thus limiting all forms of tax incentives — including subsidized credit — to activities that are considered strategic for the future development of San Marino. The budget documents should include information on investment carried out by State-owned enterprises — in particular, the Azienda Autonoma di Stato di Produzione — and the accounting of such operations should be in line with Eurostat guidelines. Transparent accounting would allow a correct assessment of the potential fiscal risk associated to loans, capital injections, and guarantees to these enterprises.

18. Financial sector policies: Sammarinese banks are relatively more efficient than banks in neighboring regions, better capitalized, and with fewer non-performing loans. Increased competition and tax amnesties in Italy―together with uncertainty about possible changes in savings taxation and bank secrecy―have, however, moderated growth in nonresidents' accounts and put pressure on profits. To maintain the competitiveness of the Sammarinese financial system and to create the conditions for its safe expansion as past tax advantages wither, we encourage the government to continue, and possibly step up, its efforts to upgrade the regulatory and legislative framework.

19. The formation of the Central Bank of San Marino (CBSM) — through the merger of the Istituto di Credito Sammarinese and the Office of Banking Supervision — is an essential building block of the government's strategy and needs to be completed with the rapid approval of the second phase of the merger law. This law — in line with international best practices — should grant adequate supervisory and regulatory powers to the CBSM and establish a governance structure that ensures its operational independence from the government, a stable source of financing, and clear lines of accountability to Parliament. The government should also take this opportunity to accord the right to grant and revoke licenses to the supervisory authority — as it is a matter of course in several other countries.

20. We welcome the planned doubling of supervisory staff by end-2004 and the intended setting up of a credit registry. We also appreciate the approval of anti-terrorism and anti-money-laundering provisions in line with international standards, and the ongoing adoption of Basel I principles and capital adequacy requirements, which should be completed as early as possible with the issuance of market risk and derivatives regulations. The intention to unify the existing legislation on banking is also laudable. The overarching objective of these reforms should be to bring the regulatory and legislative framework of the financial sector in line with that of the European Union with the ultimate aim to extend the scope of activity of Sammarinese institutions outside San Marino.

21. A supervisory practice based on frequent exchanges of information and advice has established a climate of mutual trust between the supervisory authority and the Sammarinese financial institutions and has served San Marino well. This way of operating can contribute to make San Marino appealing as a financial center to outside investors and should be maintained. There is a need, however, to integrate it with more frequent on-site inspections as the recent proliferation of banks and non-bank financial institutions — which has enhanced the number and quality of services offered — will make it more difficult for the supervisors to rely almost exclusively on continuous personal contacts and data reporting. Enforcing the highest supervisory standards is imperative because it would contribute to prevent losses of reputation and outflows of funds that any scandal or financial problem — even in a small institution — would trigger.

22. The supervisory authority also needs to gear up for the broader range of services and products that Sammarinese financial institutions will have to offer if they want to compete on an equal footing with those operating in Italy and other small financial centers. As the government introduces new legislation on insurance, mutual and pension funds, and other financial sector products or activities, the CBSM should stand ready to provide technical advice and professional supervisors.

23. In support of these efforts aimed at improving and promoting the Sammarinese financial system, we believe that the conduct of a Financial Sector Assessment Program (FSAP) could provide useful indications to San Marino and the international community. We therefore encourage the authorities to translate their stated interest in a FSAP into a formal request.

24. Statistical issues: San Marino's statistical database has improved but several shortcomings remain. The government needs to devote more resources to the compilation of general government accounts in line with Eurostat's ESA95 methodology and of timely national account statistics, as well as the collection of indicators enabling the production of GDP growth estimates. The government should also make the necessary organizational changes and assign responsibility to ensure the consistency of the data published by the Ministry of Finance and the CBSM. The availability of reliable statistics on current economic conditions and up-to-date transparent government accounts is not only important to external observers but is key to designing appropriate economic policies and preparing realistic budgets. The central bank should publish on a regular basis the collected information on the bank and nonbank financial intermediaries, while modifying banks' reporting to allow the identification of their credit and debit relationships with each entity of the general government.


Public Affairs    Media Relations
E-mail: E-mail:
Fax: 202-623-6278 Phone: 202-623-7100