## 1. External Sector Assessment

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### Context and systemic banking weaknesses
- Economic contraction and causes:
  - San Marino lost a third of its output over the past decade.
  - Causes: collapse of offshore banking model (largely due to anti-tax evasion measures by Italy), weak external demand, and tight credit conditions.
- Banking sector fragilities and consequences:
  - Over-sized banking sector shrinking; low liquidity due to deposit outflows, mainly by non-residents.
  - High NPLs and elevated operating costs eroded banks’ capital and viability, leading to multiple bank resolutions.
  - Losses from past interventions have not been properly recognized and absorbed.
  - State supports provided to the state-owned bank, Cassa di Risparmio della Repubblica di San Marino (CRSM); CRSM’s capital base remains deeply negative.
  - Full and upfront cost recognition of past bank interventions would increase public debt substantially to an unsustainable level.
  - Low CBSM liquidity buffers and lack of external market access threaten financial stability.
- Institutional constraints:
  - Progress on restoration of banking viability slow due to domestic politics and limited administrative capacity.

### Recent macro-financial developments and policy priorities
- Output, labor and prices:
  - Real GDP growth: 2017 = 0.6 percent (moderated from 2.5 percent in 2016).
  - Unemployment edged up to above 8 percent (December).
  - Headline inflation around 1.6 percent (December); core inflation 0.7 percent (December).
- Banking liquidity and supervisory posture:
  - Liquid assets-to-short-term deposits almost halved since mid-2015.
  - Two banks chronically reliant on emergency liquidity assistance (ELA) from the CBSM; one repaid ELA after asset disposals; the other under special administration with monthly deposit withdrawal limits.
  - Some banks received substantial waivers from minimum reserve requirements; two banks received a full exemption.
  - Continuous financing to banks and government contributed to a decline of about 40 percent in CBSM reserves relative to their end-2016 level.
- Asset quality and recapitalization:
  - Estimated capital shortfalls at 39 percent of GDP (54 percent of GDP when tax credits are included) (Annex I).
  - NPLs remain high at around 55 percent of total loans (post-AQR).
- Persistent losses and profitability drag:
  - Banking system estimated to have registered a loss in 2018—for the ninth year in a row—reflecting high operating costs, high NPL costs, and non-interest-bearing tax credits (15 percent of GDP) given to banks.
  - Repeal of banks’ option to convert tax credits into government bonds implies tax credits will continue to weigh on profitability and deter private capital raising.
- Fiscal position and buffers:
  - Overall fiscal deficit projected to have narrowed to 2.7 percent of GDP in 2018 from 3.6 percent of GDP in 2017.
  - State support to CRSM around 3 percent of GDP in 2018.
  - Official public debt projected about 27.5 percent of GDP in 2018.
  - Implicit public debt (including government’s commitments to the banking system) about 77 percent of GDP in 2018 (Annex V).

### External position and competitiveness assessment (EBA-lite)
- External statistics and trends:
  - San Marino produced first balance of payments and International Investment Position (IIP) statistics recently.
  - 2017 current account: deficit of 0.5 percent of GDP.
  - Net IIP declined to 261 percent of GDP in 2017 from 270 percent in 2016.
  - Real effective exchange rate (REER) broadly stable in 2018 at about two percent above its 10-year average following a prolonged appreciation.
- EBA-lite findings (Box 1):
  - CA gap model:
    - CA norm: surplus of 3.1 percent of GDP.
    - Actual CA: deficit of 0.5 percent of GDP.
    - CA gap: -3.6 percent of GDP.
    - Implied REER overvaluation: 3.2 percent.
    - Policy gap largely explains CA gap (notably slow progress in addressing banking fragilities and fiscal consolidation, and loss of international reserves by the CBSM).
  - REER Index model:
    - REER appears overvalued by 2.2 percent.
    - Lower equilibrium REER driven by lower credit level and growth in San Marino relative to trading partners.
  - Competitiveness:
    - San Marino lost about two-thirds of its world export market share compared to the pre-crisis period; competitiveness remains a key challenge.

### Outlook and baseline (“muddling-through” scenario) and key risks
- Baseline assumptions and trajectory:
  - Assumes fundamental banking problems not fully addressed; gradual banking system recapitalization; low liquidity; continued contraction of bank balance sheets.
  - Real GDP projected to grow by one percent on average in 2018–19; medium-term convergence to 0.5 percent.
  - Final consumption projected to further contract as households continue to deleverage.
  - CBSM reserves projected to decline gradually, assuming no acceleration of deposit outflows.
  - Unemployment expected to remain elevated at about 8 percent.
  - Inflation set to modestly increase.
- Macro projections (selected series, 2017–24, percent change or percent unless otherwise noted):
  - Real GDP: 2017 = 0.6; 2018 = 1.1; 2019 = 0.8; 2020 = 0.7; 2021 = 0.6; 2022 = 0.5; 2023 = 0.5; 2024 = 0.5.
  - Final consumption: 2017 = -0.9; 2018 = -0.8; 2019 = -0.7; 2020 = 0.0; 2021 = 0.0; 2022 = 0.1; 2023 = 0.1; 2024 = 0.1.
  - Fixed investment: 2017 = 9.0; 2018 = 11.6; 2019 = 3.5; 2020 = 2.1; 2021 = 1.7; 2022 = 1.7; 2023 = 1.7; 2024 = 1.7.
  - Exports: 2017 = -1.1; 2018 = 2.8; 2019 = 2.0; 2020 = 1.7; 2021 = 1.6; 2022 = 1.6; 2023 = 1.6; 2024 = 1.6.
  - Imports: 2017 = 0.0; 2018 = 2.4; 2019 = 2.1; 2020 = 1.8; 2021 = 1.7; 2022 = 1.8; 2023 = 1.8; 2024 = 1.8.
  - Unemployment: 2017 = 8.1; 2018 = 8.0; 2019 = 8.1; 2020 = 8.1; 2021 = 8.1; 2022 = 8.1; 2023 = 8.1; 2024 = 8.1.
  - Inflation rate (average): 2017 = 1.0; 2018 = 1.6; 2019 = 1.6; 2020 = 1.7; 2021 = 1.7; 2022 = 1.8; 2023 = 1.8; 2024 = 1.8.
  - Current account (percent of GDP): 2017 = -0.5; 2018 = 0.4; 2019 = 0.3; 2020 = 0.1; 2021 = 0.1; 2022 = 0.1; 2023 = 0.1; 2024 = 0.2.
- Downside risks (Annex II):
  - Domestic: slow banking sector repair leading to tighter credit, weakened confidence, liquidity pressures, and threat to financial/economic stability.
  - Fiscal: full and upfront recognition of state’s commitments to the banking sector would exacerbate fiscal risks, erode confidence, increase vulnerabilities, and raise debt-service payments crowding out productive spending.
  - External: weaker-than-expected growth in key trading partners, particularly Italy, would strain exports and affect residents working abroad.

### Policy discussions — restoring banking system viability (core recommendations)
- Overarching strategic priorities:
  - Simultaneously restore banking system viability and credit supply, safeguard public finances, and promote sustained economic growth.
  - A comprehensive strategy: deep banking system restructuring, ambitious and growth-friendly fiscal consolidation, and structural reforms to boost competitiveness.
- Recapitalization and loss recognition:
  - Incorporate AQR findings into banks’ financial statements and promptly address capital needs.
  - Repeal laws that allow banks to spread “AQR losses” over five years and protect subordinated debt holders.
  - Recapitalization must involve a mix of private contributions and public support, guided by fiscal sustainability considerations.
  - Private banks: first attempt to raise capital from private sources; banks unable to meet minimum capital requirements should face corrective action; only systemically-important and viable banks should benefit from state support.
  - CRSM specifics: CRSM incurred losses of €485 million (around 30 percent of total assets) spread over 25 years starting from 2016; government committed to recapitalize the bank with public money. Upfront loss recognition and recapitalization from public and private sources are needed, along with timely and deep balance sheet restructuring to support return to profitability and re-privatization over the medium term.
- Improve efficiency and profitability:
  - System is overbanked; cost-to-income ratio is 108.4 percent.
  - Focus on significant cost reduction, including reviewing employees’ compensation and rationalizing branch network.
  - Resist plans to increase earnings through risky innovation projects to avoid excessive risk-taking.
- Tax credits and bank viability:
  - Tax credits on banks’ balance sheets: €211 million (15 percent of GDP); do not generate income, must be funded, weigh heavily on banks’ viability, and deter private capital raising.
  - Recommendation: convert tax credits into coupon-bearing government bonds to help restore banks’ long-term sustainability.
- NPL resolution:
  - NPL ratio (post-exercise) excluding CRSM’s exposure to Delta group: 51 percent (increased from 44 percent); including closed funds: about 55 percent.
  - Bank actions: improve collection and workout capacity; engage in loan restructuring, settlement, and sales of collateral and NPLs.
  - Policy measures: strengthen supervisory oversight with ambitious NPL reduction targets; expedite liquidation and enforcement by streamlining administrative processes; modernize the insolvency regime; remove tax disincentives for NPL disposal.
- Strengthening financial sector oversight and resolution:
  - Bring CBSM resolution framework to international standards: provide purchase and assumption and bridge bank tools, strengthen liquidation powers, allow greater flexibility with burden sharing options.
  - Reform CBSM law to enhance independence, governance, accountability, and transparency; establish macro-analysis, crisis management, and communication functions.
  - Ensure supervisors have sufficient powers and resources.

### Liquidity management and Emergency Liquidity Assistance (Section 13)
- CBSM reserves and liquidity monitoring:
  - CBSM strengthened liquidity monitoring and management framework, but reserves already below adequate levels (Annex III).
- ELA framework recommendations:
  - Align ELA with best practice: restrict ELA to fully-collateralized lending and provide it only to solvent banks, contingent on approval of credible plans to repay loans at maturity.
  - Develop well-designed measures and a carefully crafted communication strategy to respond to a potential resurgence in liquidity pressures and to safeguard the payment system.
  - Limit CBSM’s budget financing to only exceptional needs and on a temporary basis to support CBSM liquidity buffers.

### Banking sector structure, selected statistics, and indicators
- Size and deposits:
  - Nonresidents’ deposits declined by nearly 90 percent.
  - Residents’ deposits account for 85 percent of total deposits and financial instruments issued to customers at end-2018.
  - Number of banks halved from twelve to six.
  - Banks’ total assets declined to 335 percent of GDP in late-2018 from 706 percent in 2008.
- Concentration:
  - Two largest banks (CRSM and Banca di San Marino (BSM)) account for nearly 60 percent of banking system total assets.
- Efficiency:
  - Number of branches per adult is the highest in Europe.
  - Cost-to-income ratio: 108.4 percent.
- Profitability and coverage:
  - NPL coverage ratio (percent): 2012: 54.8; 2013: 56.0; 2014: 55.8; 2015: 54.8; 2016: 56.0; 2017: 55.8; 2018.Sept: 55.8.
  - Return on assets (ROA): 2012: -2.2; 2013: -0.6; 2014: -1.8; 2015: -0.7; 2016: -1.0; 2017: -0.7; 2018.Sept: -0.6.
  - Return on equity (ROE): 2012: -22.5; 2013: -7.8; 2014: -21.4; 2015: -9.0; 2016: -13.2; 2017: -10.0; 2018.Sept: -8.3.
- Banking system assets:
  - Banking system assets 2018*: €4,710.3 million; percent of GDP: 339.7. (*As of November 2018.)

### Fiscal policy, public debt, and debt sustainability (Annex V highlights)
- Official and implicit public debt:
  - Official public debt: about 27.5 percent of GDP in 2018.
  - Implicit public debt (including banking system commitments): about 77 percent of GDP in 2018.
  - Composition: outstanding CRSM legacy losses: €465 million amortized over 25 years; bank tax credits: €211 million (15 percent of GDP).
- Public debt projections and vulnerabilities:
  - Official government debt (percent of GDP): 2016: 24.0; 2017: 25.9; 2018: 27.5; 2019: 28.8; 2020: 31.0; 2021: 33.6; 2022: 36.0; 2023: 38.3; 2024: 40.6.
  - Government debt (incl. CRSM legacy losses and tax credits, percent of GDP): 2016: 35.2; 2017: 76.6; 2018: 77.0; 2019: 77.1; 2020: 77.9; 2021: 78.0; 2022: 78.1; 2023: 78.2; 2024: 78.3.
  - Staff’s medium-term fiscal anchor recommendation: public debt of about 50 percent of GDP and government deposits covering at least two months of spending.
  - Staff consider sustaining a primary surplus (excluding bank support) of about 2.5 percent of GDP is feasible through revenue and expenditure measures.
- Stress-test outcomes (Annex V):
  - Real growth shock: public debt ratio increases to 82 percent of GDP by 2020, and to 90 percent of GDP by 2024.
  - Primary balance shock (1.5 percentage points deterioration in 2019–20): public debt reaches 81 percent of GDP by 2024.
  - Contingent liability shock (additional banking repair costs of 10 percent of GDP, lower growth, higher borrowing cost of 300 basis points): public debt about 100 percent of GDP by 2024; gross financing needs increase to about 9 percent of GDP.
  - Real interest rate shock (300 basis points): public debt to 80 percent of GDP by 2024.
  - Combined macro-fiscal shock (excluding contingent liability shock): public debt 84 percent of GDP by 2020, and 93 percent of GDP by 2024.
- Policy implications:
  - Limit public debt increases by implementing an ambitious and durable fiscal adjustment, strengthening public debt management, and carefully designing banking recapitalization modalities and public contributions.
  - Recognize and account transparently for banking-related fiscal commitments.

### Pension system, demographic pressures, and reform options (Annex VI)
- Demographic and fiscal context:
  - Fertility rate (current): 1.33 births per woman.
  - Average life expectancy: 84.6 years.
  - Ratio of people aged 65+ to those aged 15–64: 30 percent in 2017.
  - Staff projection: old-age dependency ratio expected to reach 60 percent by 2050 and stabilize thereafter.
  - Pension spending rose from 5 percent of GDP in 2004 to about 13 percent of GDP in 2017.
  - Pension fund reserves currently about 27 percent of GDP.
  - Baseline projection: pension spending around 26 percent of GDP by 2040 and 25 percent by 2070 (projection assumes pension growth determined only by growth of old-age dependency ratio).
  - Pension fund deficit projected to reach 10 percent of GDP by 2030.
- Reform measures already undertaken:
  - Statutory retirement ages increased and set to rise to 66 years by 2021.
  - Minimum years of contributions for old-age retirement increased to 20 years.
  - Mandatory second, fully-funded pillar (FONDISS) introduced in 2011.
  - 2019 Budget reduced favorable fiscal treatment of pension income.
- Illustrative reform trade-offs (simplified, not actuarial):
  - To stabilize pension spending at 13.3 percent of GDP by 2030:
    - Reduce pension benefits across the board by 40 percent without increasing payroll taxes or retirement age; OR
    - Increase retirement age by 5.1 years without cutting benefits or increasing payroll taxes; OR
    - Increase payroll taxes by 18.2 percentage points without raising retirement age or cutting benefits.
  - Example package (illustrative): increasing retirement age by 3 years by 2030 (reduction in pension expenditure by 3.5 percentage points of GDP) + a 15 percent benefit reduction targeted to higher pensions (savings 1.2 percent of GDP) + providing full indexation only to lower pensions and partial indexation to higher pensions (average indexation 50 percent; savings 0.8 percent of GDP) = combined reduction 5.5 percentage points of GDP by 2030 versus no-reform baseline.
- Policy guidance:
  - Further parametric reforms should be assessed through a careful actuarial review as part of ongoing policy discussions.
  - Potential reforms under discussion include increase in retirement age, transition to a defined contribution system, incentives for complementary pensions, and capping state support.

### Structural reforms, VAT implementation, and data needs
- Business environment and labor market:
  - Priority reforms: reduce red tape; streamline judicial processes; improve corporate governance; enhance creditors and borrowers’ rights.
  - Labor: further relax hiring restrictions of nonresidents; remove surcharge on hiring nonresidents; expand residency permits; strengthen Office for Active Labor Market Policies.
- VAT and revenue mobilization:
  - Monofase represented 53 percent of all indirect taxes with a collection of 4.2 percent of GDP in 2017.
  - Authorities plan to introduce a VAT in 2020 to replace the Monofase; authorities’ projections: VAT would increase revenue collection by up to one percent of GDP compared to the Monofase.
  - Implementation needs: modern/simple VAT design, sufficient rates and limited exemptions, tax administration capacity, IT upgrades, VAT refund system, information exchange with Italy.
- Data provision:
  - Progress: use of standardized Report Forms to publish IMF Monetary and Financial Statistics in 2018; balance of payments for 2017 and IIP for 2016–17 produced with IMF technical assistance.
  - Remaining gaps: further efforts needed to improve quality, frequency, and reporting of relevant statistics.
- Staff appraisal conclusion:
  - Growth prospects weighed down by legacy problems and downside risks.
  - Urgent policy adjustment needed: comprehensive banking restructuring, ambitious fiscal consolidation, and structural reforms; full stakeholder commitment critical.

*Source: 1smrea2019001 - 1. External Sector Assessment (IMF staff report).*

### 1. External Sector Assessment  ___________________________________________________________________ 7

### 1. External Sector Assessment

### Context
- Economic activity has yet to recover from the sharp downturn in the past decade; San Marino lost a third of its output.
- Causes of the collapse: collapse of San Marino’s offshore banking model (largely due to anti-tax evasion measures by Italy), weak external demand, and tight credit conditions.
- Activity bottomed out in 2015–16; subsequent recovery has been subdued.
- Fragilities in the banking system and excessive use of forbearance increased vulnerabilities:
  - Over-sized banking sector shrinking; low liquidity due to deposit outflows, mainly by non-residents.
  - High NPLs and elevated operating costs eroded banks’ capital and viability, leading to multiple bank resolutions.
  - Losses from past interventions have not been properly recognized and absorbed.
  - State supports provided to the state-owned bank, Cassa di Risparmio della Repubblica di San Marino (CRSM); CRSM’s capital base remains deeply negative.
  - Full and upfront cost recognition of past bank interventions would increase public debt substantially to an unsustainable level.
  - Low CBSM liquidity buffers and lack of external market access threaten financial stability.
- Authorities are discussing restoration of banking system viability and safeguarding public finances; progress has been slow due to domestic politics and limited administrative capacity.

### Recent developments and policy priorities
- Real GDP growth moderated to 0.6 percent in 2017 from 2.5 percent in 2016.
- High-frequency indicators for 2018 mixed; relaxation in labor market restrictions (“Development law”, 2017) boosted cross-border workers.
- Unemployment edged up to above 8 percent (December) after moderating in the first half of the year.
- Headline inflation around 1.6 percent (December); core inflation broadly stable at 0.7 percent (December).
- Banking system liquidity and deposits:
  - Liquid assets-to-short-term deposits almost halved since mid-2015.
  - Two banks chronically reliant on emergency liquidity assistance (ELA) from the CBSM; one repaid ELA after asset disposals; the other under special administration with monthly deposit withdrawal limits.
  - Some banks received substantial waivers from minimum reserve requirements; two banks received a full exemption.
  - Continuous financing to banks and government contributed to a decline of about 40 percent in CBSM reserves relative to their end-2016 level.
- Asset quality and recapitalization:
  - Estimated capital shortfalls at 39 percent of GDP (54 percent of GDP when tax credits are included) (Annex I).
  - NPLs remain high at around 55 percent of total loans (post-AQR).
- Persistent losses:
  - Banking system estimated to have registered a loss in 2018—for the ninth year in a row—reflecting high operating costs, high NPL costs, and non-interest-bearing tax credits (15 percent of GDP) given to banks.
  - Repeal of banks’ option to convert tax credits into government bonds implies tax credits will continue to weigh on profitability and deter private capital raising.
- Financial sector strategy progress slow due to divergent stakeholder views, lack of appetite for reforms, limited CBSM powers/autonomy, and a court decision in late 2018 annulling CBSM’s 2017 intervention in Asset Banca.
- Fiscal position and buffers:
  - Overall fiscal deficit projected to have narrowed to 2.7 percent of GDP in 2018 from 3.6 percent of GDP in 2017.
  - State support to CRSM around 3 percent of GDP in 2018.
  - Official public debt projected about 27.5 percent of GDP in 2018.
  - Implicit public debt (including government’s commitments to the banking system) about 77 percent of GDP in 2018 (Annex V).

### External position and assessment
- San Marino produced first balance of payments and International Investment Position (IIP) statistics recently.
- 2017 current account balance points to a deficit of 0.5 percent of GDP.
- Net IIP declined to 261 percent of GDP in 2017 from 270 percent in 2016 due to large liquidation of foreign portfolio investments by banks and decline in loans of domestic banks to nonresidents.
- Real effective exchange rate (REER) broadly stable in 2018 at about two percent above its 10-year average following a prolonged appreciation.
- Box 1 — External Sector Assessment (EBA-lite methodology) findings:
  - Current Account (CA) gap model:
    - CA norm: surplus of 3.1 percent of GDP.
    - Actual CA: deficit of 0.5 percent of GDP.
    - CA gap: -3.6 percent of GDP.
    - Implied REER overvaluation: 3.2 percent.
    - Policy gap largely explains CA gap, notably slow progress in addressing banking fragilities and fiscal consolidation, and loss of international reserves by the CBSM.
  - REER Index model:
    - REER appears overvalued by 2.2 percent.
    - Lower equilibrium REER driven by lower credit level and growth in San Marino relative to trading partners.
  - San Marino lost about two-thirds of its world export market share compared to the pre-crisis period; competitiveness remains a key challenge.

### Outlook and risks
- Baseline outlook (“muddling-through” scenario):
  - Assumes fundamental banking problems not fully addressed; gradual banking system recapitalization; low liquidity; continued contraction of bank balance sheets.
  - Real GDP projected to grow by one percent on average in 2018–19.
  - Final consumption projected to further contract as households continue to deleverage.
  - Over the medium term, growth expected to converge to 0.5 percent.
  - CBSM reserves projected to decline gradually, assuming no acceleration of deposit outflows.
  - Unemployment expected to remain elevated at about 8 percent.
  - Inflation set to modestly increase.
- Macro projections (selected series, 2017–24):
  - Real GDP: 2017 = 0.6; 2018 = 1.1; 2019 = 0.8; 2020 = 0.7; 2021 = 0.6; 2022 = 0.5; 2023 = 0.5; 2024 = 0.5 (percent change).
  - Final consumption: 2017 = -0.9; 2018 = -0.8; 2019 = -0.7; 2020 = 0.0; 2021 = 0.0; 2022 = 0.1; 2023 = 0.1; 2024 = 0.1 (percent change).
  - Fixed investment: 2017 = 9.0; 2018 = 11.6; 2019 = 3.5; 2020 = 2.1; 2021 = 1.7; 2022 = 1.7; 2023 = 1.7; 2024 = 1.7 (percent change).
  - Exports: 2017 = -1.1; 2018 = 2.8; 2019 = 2.0; 2020 = 1.7; 2021 = 1.6; 2022 = 1.6; 2023 = 1.6; 2024 = 1.6 (percent change).
  - Imports: 2017 = 0.0; 2018 = 2.4; 2019 = 2.1; 2020 = 1.8; 2021 = 1.7; 2022 = 1.8; 2023 = 1.8; 2024 = 1.8 (percent change).
  - Unemployment: 2017 = 8.1; 2018 = 8.0; 2019 = 8.1; 2020 = 8.1; 2021 = 8.1; 2022 = 8.1; 2023 = 8.1; 2024 = 8.1 (percent).
  - Inflation rate (average): 2017 = 1.0; 2018 = 1.6; 2019 = 1.6; 2020 = 1.7; 2021 = 1.7; 2022 = 1.8; 2023 = 1.8; 2024 = 1.8 (percent).
  - Current account (percent of GDP): 2017 = -0.5; 2018 = 0.4; 2019 = 0.3; 2020 = 0.1; 2021 = 0.1; 2022 = 0.1; 2023 = 0.1; 2024 = 0.2.
- Key downside risks (Annex II):
  - Domestic: slow banking sector repair leading to tighter credit, weakened confidence, liquidity pressures, and threat to financial/economic stability.
  - Fiscal: full and upfront recognition of state’s commitments to the banking sector would exacerbate fiscal risks, erode confidence, increase vulnerabilities, and raise debt-service payments crowding out productive spending.
  - External: weaker-than-expected growth in key trading partners, particularly Italy, would strain exports and affect residents working abroad.

### Authorities’ views
- Authorities broadly concurred with staff’s risk assessment but were confident that structural reforms and stronger cooperation with Italy will support growth.
- They agreed delayed action on banking sector repair endangers financial stability while excessive state support undermines fiscal sustainability.
- Authorities highlighted recent steps to ease nonresidents’ hiring and argued further business climate improvements, the conclusion of the association agreement with the EU, and a Memorandum of Understanding with the Bank of Italy could yield significant benefits.

### Policy discussions — Restoring banking system viability
- Key challenges: simultaneously restore banking system viability and credit supply, safeguard public finances, and promote sustained economic growth.
- Required actions:
  - Deep banking system restructuring, including significant cost reduction and durable resolution of NPLs.
  - Strengthening banks’ capital and liquidity positions.
  - Improvement of financial sector governance and oversight.
  - Mix of private contributions and public support to address sizable recapitalization needs.
  - Ambitious and growth-friendly fiscal consolidation and implementation of structural reforms to reduce vulnerabilities, improve competitiveness, and bolster potential growth.

*Source: 1smrea2019001 - 1. External Sector Assessment (IMF staff report).*

### 13.      Liquidity management should be urgently enhanced to preserve CBSM liquidity

### 13.      Liquidity management should be urgently enhanced to preserve CBSM liquidity

### Liquidity management and emergency liquidity assistance (ELA)
- The CBSM has strengthened its liquidity monitoring and management framework, but reserves are already below adequate levels (Annex III).
- Recommendations:
  - Align the ELA framework with best practice: restrict ELA to fully-collateralized lending and provide it only to solvent banks, contingent on approval of credible plans to repay loans at maturity.
  - Develop well-designed measures and a carefully crafted communication strategy to respond to a potential resurgence in liquidity pressures and to safeguard the payment system.
  - Limit CBSM’s budget financing to only exceptional needs and on a temporary basis to support CBSM liquidity buffers.

### Capital shortfalls in the banking system
- Urgent need to address capital shortfalls based on AQR findings:
  - Incorporate AQR findings into banks’ financial statements and promptly address capital needs.
  - Repeal laws that allow banks to spread “AQR losses” over five years and protect subordinated debt holders.
  - Recapitalization must involve a mix of private and public contributions, guided by fiscal sustainability considerations (see ¶25).
- Specific guidance:
  - Private banks: first attempt to raise capital from private sources; banks unable to meet minimum capital requirements within prescribed timeframes should face corrective action; only systemically-important and viable banks should benefit from state support.
  - State-owned CRSM: CRSM incurred losses of €485 million (around 30 percent of total assets) spread over 25 years starting from 2016; government committed to recapitalize the bank with public money. Upfront loss recognition and recapitalization from public and private sources are needed, along with timely and deep balance sheet restructuring to support return to profitability and re-privatization over the medium term.

### Improving efficiency and profitability
- The banking system requires deep restructuring to increase efficiency and restore profitability.
- Key facts:
  - System is overbanked.
  - Cost-to-income ratio is 108.4 percent.
- Recommendations:
  - Focus on significant cost reduction, including reviewing employees’ compensation and rationalizing branch network.
  - Resist plans to increase earnings through risky innovation projects to avoid excessive risk-taking.

### Tax credits and bank viability
- Tax credits on banks’ balance sheets:
  - Do not generate income, must be funded, weigh heavily on banks’ viability, and deter private capital raising.
  - Allowing tax credits to increase as recoveries from NPLs of failed banks fall introduces moral hazard and increases fiscal costs over time.
- Recommendation:
  - Convert tax credits into coupon-bearing government bonds to help restore banks’ long-term sustainability.

### Resolving NPLs
- Advancing NPL resolution is key to restoring long-term viability of banks and supporting financial intermediation.
- Bank actions:
  - Improve collection and workout capacity; engage proactively in loan restructuring, settlement, and sales of collateral and NPLs.
  - Supervisors should monitor efforts and remove legal, regulatory, and tax impediments.
- Policy measures to facilitate faster NPL resolution:
  - Strengthen supervisory oversight to ensure credible NPL resolution strategies with ambitious and realistic NPL reduction targets; set expectations on loan-loss provisioning adequacy and timeliness of write-offs.
  - Expedite and maximize recovery values through liquidation and enforcement by streamlining administrative processes, lowering taxes and fees related to enforcement, and adequately staffing the judicial system.
  - Facilitate rehabilitation for viable debtors by modernizing the insolvency regime and increasing flexibility of in-court restructuring agreements; draft legislation to facilitate out-of-court debt restructuring is welcome but would benefit from wider creditor participation and stronger creditor protection.
  - Remove tax disincentives for NPL disposal by relaxing the cap on tax deductibility of loan-loss provisions, eliminating time limits for tax deductibility of write-offs, and removing the transaction tax on debt transfers.

### Strengthening financial sector oversight and reducing risks
- Bank resolution framework needs overhaul:
  - CBSM’s resolution tools are limited to recovery operations or winding down failing banks.
  - Bring CBSM resolution framework to international standards by providing purchase and assumption and bridge bank tools, strengthening bank liquidation powers, and allowing greater flexibility with burden sharing options.
- Regulatory and supervisory reforms:
  - Reform CBSM law to enhance independence, governance, accountability, and transparency.
  - Establish macro-analysis, crisis management, and communication functions.
  - Ensure banking supervisors have sufficient powers and adequate resources to implement the financial sector strategy, carry out regular inspections, and monitor systemic risks.
- Financial integrity:
  - Authorities reported transposition of the 4th EU AML Directive, implementation of risk-based supervision by the Financial Intelligence Agency (FIA), and strengthening AML/CFT frameworks following the AML National Risk Assessment and Action Plan.
  - OECD Global Forum peer review upgraded San Marino’s overall rating from “Largely Compliant” to “Compliant”; the EU removed San Marino from its tax haven gray list.
  - Continued efforts needed: implement OECD BEPS actions, strengthen FIA-police collaboration, and improve transaction monitoring by financial institutions.
  - Authorities plan to prepare a second National Risk Assessment.

### Banking sector structure and performance (selected statistics and facts)
- Deposit dynamics and system size:
  - Nonresidents’ deposits declined by nearly 90 percent.
  - Residents’ deposits account for 85 percent of total deposits and financial instruments issued to customers at end-2018.
  - Number of banks halved from twelve to six.
  - Banks’ total assets declined to 335 percent of GDP in late-2018 from 706 percent in 2008.
- Concentration:
  - Two largest banks (CRSM and Banca di San Marino (BSM)) account for nearly 60 percent of banking system total assets.
- Efficiency:
  - Number of branches per adult is the highest in Europe.
  - Cost-to-income ratio: 108.4 percent.
- Data notes:
  - Banking System Assets: Total assets (% of GDP) and Total assets (millions of euros) series noted; *As of November 2018.*

### Authorities’ views on banking sector repair
- Authorities recognize urgency but highlight challenges:
  - Constraints in reaching agreement on a financial sector strategy due to substantial recapitalization costs; favor a gradual approach to recapitalization to mitigate fiscal impact.
  - Burden sharing, including applied to subordinated debt, is contentious.
  - Need to fully guarantee pension deposits to boost confidence and relieve liquidity pressures.
  - Acknowledge banks must improve efficiency, including substantial cost reduction.
  - CBSM recognizes need for improved powers and tools and highlighted recent actions such as improving liquidity management and the AQR disclosure process.
- Near-term plans:
  - Examine banks’ proposed recapitalization programs, strengthen oversight and governance, accelerate NPL reduction, and increase cooperation with the Bank of Italy.
  - Government, as main shareholder of CRSM, aware of need to recognize losses, recapitalize, and restructure CRSM; a system-wide approach to reduce NPLs is being prepared by the banks.

### Safeguarding public finances and ensuring debt sustainability
- 2019 budget:
  - Aims to achieve a balanced position, net of government transfers to CRSM.
  - Includes new measures projected to partly offset expired one-off measures in 2018 and keep fiscal position excluding transfers to CRSM broadly balanced.
  - Relies partly on one-off measures such as building regularization and tax on companies’ real estate; reduction in transfers to the Institute of social security (ISS) is not sustainable without further pension reforms (Annex VI).
- Projected transfers and deficit:
  - Budget includes an allocation to CRSM of €10 million.
  - Staff’s estimate of total allocation to CRSM implies the deficit is projected to be 2.4 percent of GDP, which—with no fiscal adjustment in the course of the year—is expected to be largely financed by continued reliance on CBSM loans.
- Public debt assessments:
  - Official public debt stood at 26 percent of GDP in 2017 and is projected to creep up to about 41 percent of GDP in 2024 under gradual recapitalization and continued forbearance on tax credits.
  - A full and upfront cost recognition of past bank interventions would put public debt at about 77 percent of GDP in 2017 (public debt including tax credits and CRSM legacy losses: 76.6; 77.0; 77.1; 77.9; 78.0; 78.1; 78.2; 78.3 percent of GDP cited in tabular series).
  - At that level, gross financing needs would account for about one-third of total revenue.
- Fiscal anchor and adjustment needs:
  - Staff’s analysis indicates a public debt of about 50 percent of GDP and government deposits covering at least two months of spending are appropriate medium-term fiscal anchors for San Marino.
  - Banking system recapitalization needs to be supported by private contributions and an ambitious, but socially acceptable, fiscal adjustment.
  - Staff consider sustaining a primary surplus (excluding bank support) of about 2.5 percent of GDP is feasible through revenue and expenditure measures.
- Possible fiscal adjustment measures (cumulative % of GDP relative to 2018):
  - 2019: Total Adjustment 0.4 = Tax Increase 0.3; VAT 0.6; Other revenue measures 0.3; Spending Cuts 0.1; Pension Reform 0.5; Spending Review 0.1.
  - 2020: Total Adjustment 1.7 = Tax Increase 0.9; VAT 0.6; Other revenue measures 0.3; Spending Cuts 0.8; Pension Reform 0.5; Spending Review 0.3.
- Additional PFM reforms:
  - Reform budget formulation, strengthen macro-fiscal planning, enhance fiscal reporting and transparency.
  - Set up a Treasury department within the Ministry of Finance to improve debt management capacity and diversify sovereign financing sources.

### VAT implementation and revenue mobilization
- Authorities plan to introduce a VAT in 2020 to replace the Monofase:
  - Monofase represented 53 percent of all indirect taxes with a collection of 4.2 percent of GDP in 2017.
  - Authorities’ projections: VAT would increase revenue collection by up to one percent of GDP compared to the Monofase.
- Implementation challenges and requirements:
  - Need a modern and simple VAT system with sufficiently high rates and limited exemptions; address tax administration capacity; set a comprehensive implementation plan; restructure and re-train the Tax Office workforce; upgrade IT systems.
  - Other key elements: sound VAT refund system, efficient exchange of information with Italy on cross-border matters, mitigation of tax avoidance and evasion.
  - Two IMF technical assistance missions (May and November 2018) guided the authorities on implementation issues.

*Source: IMF staff.*

### 28.      Sustained efforts are needed to improve the

### 28.      Sustained efforts are needed to improve the business environment.

### Business environment — findings and priorities
- Notwithstanding the welcome improvement in San Marino’s Doing Business score in recent years, the economy still performs poorly in several indicators, suggesting scope to reduce structural impediments to better attract foreign investment and improve external competitiveness.
- Priority reforms:
  - Further reducing red tape.
  - Streamlining the judicial processes.
  - Improving corporate governance.
  - Enhancing creditors and borrowers’ rights.

### Labor supply and labor-market policies
- Strengthening labor supply will support higher productivity and enhance growth prospects.
- Recent policy action:
  - The “Development Law” eased the process for hiring nonresidents and has shown results.
- Recommended further measures:
  - Removing the surcharge on hiring nonresidents.
  - Expanding the range of residency permits to foreign workers.
  - The Office for Active Labor Market Policies could support higher employment and growth by more targeted social benefits as well as enhanced training and job search.

### Economic integration, market access, and infrastructure
- Increasing economic integration and addressing infrastructure gaps would increase competitiveness and help expand market access.
- Ongoing and prospective initiatives:
  - The newly-established Economic Development Agency is expected to help expand market access for domestic firms, attract tourists, and promote higher foreign direct investments.
  - A conclusion of the Association Agreement with the EU would bring benefits, including by simplifying the operations of Sammarinese firms abroad.
- Complementary priorities:
  - Higher investment in telecommunication and transportation to improve business connectivity with trading partners.

### Authorities’ views
- Authorities reiterated commitments to tackle structural impediments and favor further integration with Italy and EU to provide domestic companies better opportunities to expand and operate abroad.
- Infrastructure priorities emphasized:
  - Improving telecommunication (important investment already made) and transportation to increase connectivity and promote higher growth.
- Given tight budget constraints, authorities favored facilitating higher private investment by:
  - Subsidizing firms’ loan interest payments.
  - Expanding tax incentives.
  - Reducing red tape.
  - Utilizing public-private partnerships.
- Authorities emphasized untapped potential in the tourism sector and plan to boost hotels’ capacity and develop skills in this sector.

### Data provision — progress and gaps
- Progress:
  - Authorities started using standardized Report Forms to publish the IMF Monetary and Financial Statistics in 2018.
  - With IMF technical assistance, balance of payment statistics for 2017 and international investment position for 2016–17 were produced.
- Remaining gaps and needs:
  - Data provision is broadly adequate for surveillance, but gaps in balance of payment and external debt components exist.
  - Further efforts are required to improve the quality, frequency, and reporting of relevant statistics so businesses and policymakers can better assess the state of the economy and make informed decisions.

### Staff appraisal — macro-financial assessment and recommended strategy
- Growth outlook and risks:
  - San Marino’s growth prospects are weighed down by legacy problems and downside risks.
  - Past failures and deep-rooted weaknesses in the banking system have dampened credit conditions, undermined economic activity, and are now threatening financial stability and fiscal sustainability.
  - Real GDP growth is set to remain subdued over the near and medium term on the back of continued banking system deleveraging and less favorable external conditions while elevated financial and fiscal fragilities pose significant downside risks.
  - The external position is weaker than implied by fundamentals and desirable policy settings.
- Urgent policy adjustment needed:
  - A comprehensive strategy is required, consisting of banking system restructuring, an ambitious and growth-friendly fiscal consolidation, and structural reforms to boost competitiveness and bolster growth.
  - A full commitment of all stakeholders in San Marino is critical for successful implementation.

### Banking sector recommendations
- Safeguard CBSM liquidity buffers:
  - CBSM reserves should be brought to adequate levels.
  - Align the ELA framework with best practice.
  - Restrict CBSM budget financing to only exceptional needs and on a temporary basis.
  - Develop measures and a carefully-crafted communication strategy to respond to potential liquidity pressures and safeguard the payment system.
- Rapid restructuring is critical:
  - Upfront loss recognition and recapitalization are needed to improve confidence, restore financial intermediation, and increase banks’ resilience to shocks.
  - Systemically-important and viable banks should benefit from state support to the extent feasible following burden sharing.
  - Undercapitalized banks that fail to raise fresh capital from private sources should be subject to corrective action.
  - Convert tax credits held by banks into government bonds and significantly reduce banks’ operating costs to support viability and capacity to build capital internally.
  - Reduce high NPL levels to safe levels over the medium term through intensive supervisory oversight of NPL reduction targets and measures to remove tax, legal, and regulatory impediments.

### Financial oversight and integrity
- Strengthen oversight and reduce risks:
  - Enhance CBSM’s intervention powers and tools to improve financial safety nets.
  - Strengthen supervisory capacity for effective risk monitoring and timely interventions in failing banks.
  - Review the Central Bank law to enhance independence, governance, and accountability.
  - Sustain efforts to contain financial integrity risks, including in the context of the ongoing preparation of the second National Risk Assessment.

### Fiscal policy and public debt
- Putting public debt on a sustainable path and gradually building fiscal buffers require a broader fiscal strategy:
  - Limit the state’s contribution to bank recapitalization.
  - Adopt a credible fiscal adjustment relying on indirect tax and pension reforms, rationalization of wasteful tax rebates, and improvement of spending efficiency.
  - Strengthen debt management capacity and diversify sovereign financing sources to reduce fiscal risks.

### Structural reforms to boost growth
- Key areas:
  - Strengthen the labor supply by further relaxing hiring restrictions of nonresidents, better targeting social benefits, and delaying the retirement age.
  - Further improve the business climate.
  - Increase economic integration and close infrastructure gaps, particularly in transportation and telecommunication, to boost foreign investment and medium-term growth.

### Data and institutional capacity — continued priorities
- Sustain efforts to improve data provision and reporting:
  - Ensure sufficient resources are allocated to the Statistical Office and the CBSM to close remaining data gaps and improve the frequency, coverage, and reporting of relevant statistics.
  - Improved statistics would allow businesses and policymakers to make informed decisions.

*Source: IMF staff report text excerpts (paragraphs 28–40).*

### 41.      Staff propose that the next Article IV consultation with the Republic of San Marino

### Staff propose that the next Article IV consultation with the Republic of San Marino follows the standard 12-month cycle.

### Macroeconomic developments
- Economic activity has recovered from a prolonged recession, yet real GDP remains well below its pre-crisis levels.
- Real GDP (percent change): 2016: 2.5; 2017: 0.6; 2018 (Prel.): 1.1; 2019 (Projection): 0.8; 2020: 0.7; 2021: 0.6; 2022: 0.5; 2023: 0.5; 2024: 0.5.
- Employment growth picked up, but unemployment slightly increased after moderating in early 2018.
  - Employment (percent change): 2016: 1.0; 2017: 1.1; 2018 (Prel.): 2.4; 2019 (Projection): 1.2; 2020: 0.5; 2021: 0.3; 2022: 0.3; 2023: 0.3; 2024: 0.3.
  - Unemployment rate (average; percent): 2016: 8.6; 2017: 8.1; 2018 (Prel.): 8.0; 2019–2024: 8.1 (annual entries show 8.0–8.1).
- Inflation rate (average; percent): 2016: 0.6; 2017: 1.0; 2018 (Prel.): 1.6; 2019–2024: 1.6, 1.6, 1.7, 1.7, 1.8, 1.8 respectively.
- External trade contribution to growth: exports and imports both large shares of GDP (see balance of goods and services figures below).

### High-frequency indicators
- Exports increased, driven by improved external conditions, but sharply moderated in late 2018.
  - Exports (millions of euros): 2017: 1,579.6; 2018: 1,624.7; 2019 (Proj.): 1,668.8; 2020: 1,708.7; 2021: 1,749.2; 2022: 1,792.4; 2023: 1,836.9; 2024: 1,882.5.
  - Imports (millions of euros): 2017: 1,464.1; 2018: 1,503.7; 2019 (Proj.): 1,549.2; 2020: 1,591.0; 2021: 1,630.9; 2022: 1,671.8; 2023: 1,712.2; 2024: 1,754.6.
- PMI showed expansion in manufacturing activity up to Q2 2018.
- Manufacturing: number of enterprises and employment increased during 2018; financial sector continued to downsize.
- Tourism: visitors declined in most of 2018, while hotel stays remained broadly unchanged.
- Housing construction picked up from low levels; car registrations dropped.

### Fiscal developments and public finances
- Public interventions in the banking sector contributed to a deterioration of the primary fiscal balance.
- Excessive state commitments to the banking system resulted in a significant increase in public debt in 2017.
- Government revenues are below the euro area average.
  - EuroArea average government revenue 2017: 42.2% of GDP (reference).
- Government expenditure composition (2017, Millions of Euros): Goods and Services: 26.1; Interest: 4.0; Wages: 94.8; Transfers: 217.4.
- Selected fiscal aggregates (central government, percent of GDP):
  - Revenue (percent of GDP): 2016: 23.3; 2017: 22.1; 2018: 22.9; 2019–2024 projections around 20.9–22.9.
  - Expenditure (percent of GDP): 2016: 23.4; 2017: 25.7; 2018: 25.7; 2019–2024 projections around 23.3–25.7.
  - Overall balance (percent of GDP): 2016: -0.2; 2017: -3.6; 2018: -2.7; 2019: -2.4; 2020: -3.0; 2021: -3.2; 2022: -3.0; 2023: -2.9; 2024: -2.9.
  - Primary balance (percent of GDP): 2016: 0.1; 2017: -3.3; 2018: -2.3; 2019: -2.0; 2020: -2.5; 2021: -2.6; 2022: -2.3; 2023: -2.2; 2024: -2.1.
  - Primary balance net of bank support (percent of GDP): 2016: 0.9; 2017: -0.4; 2018: 0.8; 2019: 0.4; 2020: -0.3; 2021: -0.6; 2022: -0.5; 2023: -0.5; 2024: -0.6.
- Public debt:
  - Government debt (official, percent of GDP): 2016: 24.0; 2017: 25.9; 2018: 27.5; 2019: 28.8; 2020: 31.0; 2021: 33.6; 2022: 36.0; 2023: 38.3; 2024: 40.6.
  - Government debt (incl. CRSM legacy losses and tax credits, percent of GDP): 2016: 35.2; 2017: 76.6; 2018: 77.0; 2019: 77.1; 2020: 77.9; 2021: 78.0; 2022: 78.1; 2023: 78.2; 2024: 78.3.
- Tax revenues (Millions of Euros): 2006–2017 series shown; 2017 tax revenues: 20 (table format) — see main tables for full series.
- Net acquisition of non-financial assets (Millions of Euros): 2016: 2.0; 2017: 2.2; 2018: 3.6; 2019–2024: 4.0, 4.5, 4.5, 4.6, 4.7, 4.8 respectively.

### Financial sector developments and soundness
- Downsizing of the Sammarinese banking sector has continued since the global financial crisis, due to outflows of deposits and certificates of deposit, largely by non-residents.
- Liquidity situation deteriorated since 2015 due to deepening banking sector fragilities.
- Banks continue to report losses, reflecting high operational cost and a high share of assets that do not generate income.
- Banking system funding (Billions of euros): time series shown for resident deposits, non-resident liabilities, debt securities, other liabilities (2008–2018).
- Banking sector assets (millions of euros, and percent of GDP): banking system assets 2018*: 4,710.3 million euros; percent of GDP: 339.7.
- Nonperforming loans and coverage:
  - NPL ratio (CBSM supervisory data, percent): 2012: 50.0; 2013: 54.0; 2014: 53.0; 2015: 52.6; 2016: 50.0; 2017: 54.0; 2018.Sept: 53.0 (Table 5 shows series).
  - NPL coverage ratio (percent): 2012: 54.8; 2013: 56.0; 2014: 55.8; 2015: 54.8; 2016: 56.0; 2017: 55.8; 2018.Sept: 55.8 (Table 1 and Table 5 entries).
- Profitability and performance (percent of average total assets):
  - Net profit and pre-provision income series show negative profitability through 2018* (Figure data).
  - Return on assets (ROA): 2012: -2.2; 2013: -0.6; 2014: -1.8; 2015: -0.7; 2016: -1.0; 2017: -0.7; 2018.Sept: -0.6.
  - Return on equity (ROE): 2012: -22.5; 2013: -7.8; 2014: -21.4; 2015: -9.0; 2016: -13.2; 2017: -10.0; 2018.Sept: -8.3.
- Depository corporate survey highlights (selected):
  - Net foreign assets (Millions of euros): 2012: 2,600.1; 2013: 2,643.5; 2014: 2,512.2; 2015: 2,340.4; 2016: 2,136.5; 2017: 1,868.3; 2018.Aug: 1,844.5.
  - Broad Money (end of period, Millions of euros): 2012: 1,472.8; 2013: 1,539.1; 2014: 1,635.1; 2015: 1,430.0; 2016: 1,466.7; 2017: 1,441.6; 2018.Aug: 1,424.2.
  - Deposits percent change: 2016: -5.6; 2017: -12.3; 2018: -1.5 (Table 1 notes).

### Balance of payments and external position
- Current account balance (Millions of euros): 2017: -6.9; 2018: 5.5; 2019 (Proj.): 5.3; 2020: 2.7; 2021: 1.9; 2022: 1.5; 2023: 1.6; 2024: 3.6.
  - Current account (percent of GDP): 2017: -0.5; 2018: 0.4; 2019 (Proj.): 0.4; 2020: 0.2; 2021: 0.1; 2022: 0.1; 2023: 0.1; 2024: 0.2.
- Balance of goods and services (percent of GDP): 2017: 7.3; 2018: 7.6; 2019: 7.2; 2020: 6.7; 2021: 6.5; 2022: 6.5; 2023: 6.6; 2024: 6.8.
- Gross international reserves (GIR, millions of euros, memorandum):
  - GIR: 2017: 258.5; 2018: 252.5; 2019 (Proj.): 232.5; 2020: 212.5; 2021: 192.5; 2022: 172.5; 2023: 152.5; 2024: 132.5.
  - GIR in months of imports: 2017: 1.5; 2018: 1.4; 2019: 1.3; 2020: 1.1; 2021: 1.0; 2022: 0.9; 2023: 0.8; 2024: 0.6.

### Key social and structural indicators
- GDP per capita (2016): 45,670 U.S. dollars.
- Life expectancy at birth (2017): 84.7 years.
- Population (2017): 33,328 persons.
- Literacy, adult (2015): 96 percent.

*Source: IMF staff and Sammarinese authorities (figures and tables as provided).*

### Annex I. Asset Quality Review and Staff’s Estimate of Bank

### Annex I. Asset Quality Review and Staff’s Estimate of Bank Recapitalization Needs

### Asset Quality Review (2017 AQR update): scope and methodology
- The CBSM updated the Asset Quality Review (2017 AQR update) to reassess banks’ asset quality and identify recapitalization needs, updating the 2016 AQR (which used June 2016 data).
- The 2017 update:
  - Was carried out by the CBSM with assistance of another consulting firm.
  - Used June 2017 data.
  - Broadly followed the ECB comprehensive assessment methodology for data integrity validation, assessment of loan classifications, collateral valuations, and loan provisions.
  - Largely relied on the 2016 AQR and did not involve fresh credit file reviews or independent collateral valuations.
- Coverage:
  - Six banks, one leasing company, and one closed NPL fund.
  - These entities comprise about 91 percent of San Marino financial system’s assets when CRSM’s exposure to Delta and other closed NPL fund assets are excluded.
- Capital and provisioning assessments were performed against both international standards (Basel III) and San Marino regulations.

### Estimated recapitalization needs and asset quality metrics
- Estimated capital shortfall based on the 2017 AQR update:
  - €540 million (39 percent of GDP) under San Marino capital requirements.
- Composition of end-2018 capital shortfall:
  - Outstanding CRSM legacy losses: €465 million.
  - Re-estimated capital shortfalls in the banking system based on the 2017 AQR update: €75 million.
- Notes on standards:
  - San Marino capital requirements are materially weaker than international standards.
  - Application of fully loaded Basel III standards would require significantly higher capital levels due to higher provisioning, higher minimum capital requirements and full deduction of deferred tax assets (DTAs).
  - Additional capital needs under Basel III are estimated as the sum of (i) additional capital shortfalls under Basel III identified by the 2017 AQR update, (ii) outstanding DTAs at end-2017, and (iii) expected increase in DTAs due to additional losses to be recorded under the application of Basel III.
- Non-performing loan (NPL) ratios from the exercise:
  - NPL ratio (excluding CRSM’s exposure to Delta group): increased to 51 percent from 44 percent.
  - NPL ratio including NPLs in the closed funds: about 55 percent.
  - NPL ratio would be even higher if residual exposure to Delta Group (subsequent to the 2018 sale of Delta Arcade portfolio) were included.

### Bank tax credits and their implications
- Tax credits held by banks: €211 million (15 percent of GDP).
- Origin and characteristics:
  - Result from past bank resolutions funded by the government by providing tax credits to banks that acquired a failed bank as compensation for excess liabilities over assets of the failed bank.
  - The tax credits do not generate any income, but must be funded.
  - They constitute an indirect tax on banks, weigh heavily on profitability, and act as a major deterrent to attracting fresh private investment.
- Policy implication:
  - Replacing tax credits with interest-bearing assets (e.g., government bonds) would help restore banks’ viability and improve attractiveness for private investors.

### Overall recapitalization estimate and recommended approach
- Total outstanding recapitalization needs (sum of capital shortfalls and tax credits): €751 million (54 percent of GDP).
- Recommended sequencing and actions:
  - Private banks should be required to promptly address their capital shortfalls from private sources.
  - Banks failing to meet capital requirements should be subject to corrective action or, if systemically important, receive necessarily restricted state support following agreement on a recapitalization and restructuring plan.
  - A strategy to meet additional recapitalization needs to implement Basel III should be considered carefully.
- Caution:
  - Estimates are based on the 2017 AQR update results, which are becoming outdated with time; therefore, prudence is warranted in planning and implementation.

*Source: Annex I. Asset Quality Review and Staff’s Estimate of Bank Recapitalization Needs (IMF staff summary).*

### Annex V. Debt Sustainability Analysis

### Annex V. Debt Sustainability Analysis

### Summary findings on public debt and banking-related commitments
- Banking system recapitalization needs jeopardize public debt sustainability.
- Staff estimate the implicit public debt at about 77 percent of GDP in 2018, well above the official public debt of 27.5 percent of GDP.
- The government committed to amortize the CRSM legacy losses of €465 million over 25 years, but these costs have yet to be fully recognized as part of public debt.
- Banking system tax credits given to banks to cover asset-liability gaps are also not fully recognized as fiscal liabilities.
- The baseline underscores the need for:
  - an ambitious and durable fiscal adjustment,
  - stronger public debt management, and
  - carefully controlled public sector contributions in the banking system recapitalization strategy to limit public debt increases.

### Baseline projections and financing needs
- Implicit public debt trajectory:
  - Projected to increase slightly to 78.3 percent of GDP by 2024 under the staff baseline scenario.
- Gross financing needs:
  - Projected to remain at around 5 percent of GDP, increasing over time.
- Interest treatment caveat:
  - The baseline does not include interest payments on unrecognized fiscal costs since no debt has been formally issued.
  - Incorporation of estimated interest payments of the implicit public debt would increase gross financing needs to about 8 percent of GDP (around 30 percent of revenue), posing significant rollover risks given limited domestic financing options, no market access, and weak debt management capacity.
  - The issuance of government debt would result, depending on the structure of debt, in additional 1–1.5 percent of GDP interest payments between 2019–24.

### Adverse scenarios and stress-test results
- Standardized adverse scenarios applied to the baseline include low growth, deterioration in the primary balance, realization of contingent liabilities, and high borrowing costs. Key scenario outcomes:
  - Real growth shock:
    - Assumes real GDP growth declines by one-standard deviation below baseline during 2019–20 and the interest rate increases by 25 basis points for one percent of GDP deterioration of the primary balance.
    - Public debt ratio would increase to 82 percent of GDP by 2020, and to 90 percent of GDP by 2024.
  - Primary balance shock:
    - A deterioration of 1.5 percentage points of GDP in the primary balance in both 2019–20 increases public debt by 3 percentage points relative to the baseline, reaching 81 percent of GDP by 2024.
  - Contingent liability shock:
    - Additional banking repair costs of 10 percent of GDP, lower growth in 2019–20, and higher borrowing cost (additional 300 basis points) raise public debt to about 100 percent of GDP by 2024.
    - Gross financing needs increase to about 9 percent of GDP.
  - Real interest rate shock:
    - An interest rate increase of 300 basis points projects public debt to 80 percent of GDP by 2024.
  - Combined macro-fiscal shock (excluding the contingent liability shock):
    - Public debt would reach 84 percent of GDP by 2020, and 93 percent of GDP by 2024.
- Stress tests indicate public debt is highly vulnerable to adverse macroeconomic conditions.

### External debt and external vulnerability
- Historical and projected gross external debt:
  - Gross external debt stood at 89 percent of GDP in 2017.
  - Projected to have declined to 78 percent of GDP in 2018.
  - Projected to decline to 53 percent of GDP by 2024, driven by continued capital outflows, including from the banking system.
- Risks to the external-debt outlook:
  - All else equal, lower growth, a deterioration in the current account, and slower domestic price growth relative to key trading partners (real exchange rate depreciation) would lead to a higher external debt trajectory relative to the baseline.
- Table A5.1 baseline external-debt line (in percent of GDP): 2017: 89.4; 2018: 77.6; 2019: 69.3; 2020: 62.8; 2021: 59.9; 2022: 57.7; 2023: 55.4; 2024: 52.9.

### Identified debt-creating flows and automatic dynamics (public sector)
- Key baseline figures (in percent of GDP unless otherwise noted):
  - Nominal gross public debt: 2017: 29.9; 2018: 76.6; 2019: 77.0; 2020: 77.1; 2021: 77.9; 2022: 78.0; 2023: 78.1; 2024: 78.2; 2024 (alternate label) 78.3.
  - Public gross financing needs: 2017: 4.2; 2018: 4.5; 2019: 3.9; 2020: 3.9; 2021: 4.9; 2022: 5.6; 2023: 5.8; 2024: 6.1; 2024 (alt) 6.5.
  - Real GDP growth (in percent): 2017: -2.0; 2018: 0.6; 2019: 1.1; 2020: 0.8; 2021: 0.7; 2022: 0.6; 2023: 0.5; 2024: 0.5.
  - Inflation (GDP deflator, in percent): 2017: 1.0; 2018: 1.4; 2019: 1.3; 2020: 1.3; 2021: 1.4; 2022: 1.5; 2023: 1.5; 2024: 1.5.
  - Effective interest rate (in percent): 2017: 0.6; 2018: 0.8; 2019: 0.5; 2020: 0.6; 2021: 0.7; 2022: 0.8; 2023: 0.9; 2024: 1.0; (another series) up to 1.2.
  - Primary deficit (identified debt-creating flow, cumulative 2019–24): 14.1 (sum shown in table).
  - Primary (noninterest) revenue and grants, cumulative 2019–24: 124.5.
  - Primary (noninterest) expenditure, cumulative 2019–24: 138.6.
- Automatic debt dynamics contribution (interest rate/growth differential) cumulative over projection: -5.6 percent of GDP.

### Caveats and data limitations
- Gross external debt in the analysis does not include FDI debt instrument liabilities due to lack of data; gross financing needs may therefore be underestimated.
- Limited availability of external sector historical data required assumptions about averages and standard deviations of key variables used in stress tests (non-interest current account balance, export and import growth, non-debt creating capital flows).
- The largely green heat map presented is not indicative for San Marino because debt thresholds are calculated for countries with established market access.

### Policy implications and priorities
- Limit public debt increases by:
  - implementing an ambitious and durable fiscal adjustment;
  - strengthening public debt management; and
  - carefully designing banking system recapitalization modalities and controlling public sector contributions.
- Recognize and account transparently for banking-related fiscal commitments (CRSM legacy losses and tax credits) to reflect true public debt exposure and associated interest-cost implications.

*Source: IMF staff. Annex V. Debt Sustainability Analysis.*

### Annex VI. Demographic Pressure and Pension Reform

### Annex VI. Demographic Pressure and Pension Reform

### A. Introduction
- Population ageing will pose significant fiscal challenges in San Marino.
- Fertility rates are projected to remain below replacement levels, contributing to slower population growth and higher life expectancy.
- Pension reform is included in the National Stability and Development Plan and is timely given fiscal risks from banking system recapitalization and the fiscal adjustment needed for public debt sustainability.

### B. Demographic Outlook
- Key demographic indicators and projections:
  - Fertility rate (current): 1.33 births per woman.
  - Average life expectancy: 84.6 years.
  - Ratio of people aged 65+ to those aged 15–64: 30 percent in 2017.
  - Staff projection: old-age dependency ratio expected to reach 60 percent by 2050 and stabilize thereafter.
- Data sources and projection notes:
  - UN projections (2017 Revision of the UN World Population Prospect) used for population and fertility assumptions (medium-variant).
  - Old-age dependency ratio for San Marino projected using Economic Policy Committee’s Working Group projections for Italy (UN does not provide this ratio for San Marino).
  - Demographic context: population growth will continue but at a slower pace and is projected to start declining by 2050.

### C. Challenges from Population Ageing
- Recent fiscal and pension trends:
  - Pension spending rose from 5 percent of GDP in 2004 to about 13 percent of GDP in 2017.
  - The ratio of pensioners to population aged 65+ increased from 107 in 2000 to 138 percent in 2017.
  - Pension fund reserves currently about 27 percent of GDP.
- Drivers of increased pension spending:
  - Higher longevity increasing the old-age dependency ratio.
  - Spending per pensioner grew faster than GDP per worker after the economic crisis and GDP contraction.
  - Growth in contributions (via higher contribution rates and longer contributory periods) stalled after the crisis due to lower labor force participation.
- Projections and fiscal risks:
  - Baseline projection: pension spending around 26 percent of GDP by 2040 and 25 percent by 2070 (projection assumes pension growth is determined only by growth of old-age dependency ratio).
  - Pension fund deficit projected to reach 10 percent of GDP by 2030.
  - Assumption: central government transfers to ISS capped at a maximum of 25 percent of total contributions—likely insufficient to finance the deficit without reserve drawdown.
  - Pension fund reserves projected to finance deficits only up to 2030, after which depletion will exert unsustainable budget pressures.
  - Rapid reserve depletion may have systemic implications for the banking system given low liquidity.

### D. Reform Options
- Reforms already implemented:
  - Statutory retirement ages increased and set to rise to 66 years by 2021.
  - Minimum years of contributions for old-age retirement increased to 20 years; early retirement possible at age 60 with at least 40 years of contributions.
  - Mandatory second, fully-funded pillar (FONDISS) introduced in 2011 and mandatory for dependent and self-employed.
  - 2019 Budget reduced favorable fiscal treatment of pension income by reducing income tax deduction on pensions.
  - Contribution rates for mandatory individual accounts: 2 percent of gross earnings (payroll) for employees (employers) and 3 percent of income for self-employed.
- Structural characteristics and comparisons:
  - Benefit ratio (average pensions divided by average wages): 71 percent in San Marino versus EU average of 50 percent.
  - Reference earnings for benefit calculation: average daily earnings of the last 20 years (10 years before 2012), adjusted for cost of living index, divided by contributing days and multiplied by 16.615.
  - San Marino accrual rates and formula: an accrual rate 2 percent multiplied by years of contributions until half of legally established average annual income (€45,501 for 2018); a 0.75 percent rate (1.5 percent for coverage before 2012) used for excess amount—leading to an average replacement rate of 55 percent.
  - Comparators: average accrual rates in Europe between 1.5 and 1.7 percent, guaranteeing replacement rates around 50 percent.
  - Early retirement penalties are low: retiring at 57 (eight years early) incurs a total penalty of 20 percent (comparator countries range 38.4–57.6 percent); retiring six years early incurs a penalty of 10 percent.
- Quantified reform trade-offs and illustrative scenarios (based on a simplified pension expenditure projection model; not actuarial):
  - To stabilize pension spending at 13.3 percent of GDP by 2030:
    - Reduce pension benefits across the board by 40 percent without increasing payroll taxes or retirement age; OR
    - Increase retirement age by 5.1 years without cutting benefits or increasing payroll taxes; OR
    - Increase payroll taxes by 18.2 percentage points without raising retirement age or cutting benefits.
  - Combinations of measures could stabilize pension spending with modest increases in social contribution rates.
  - Capping state support at 2 percent of GDP could lead to savings of about 1 percent of GDP per year while allowing stabilization of pension reserves by 2030.
  - Illustrative package example (not actuarial): increasing retirement age by 3 years by 2030 would yield a reduction in pension expenditure by 3.5 percentage points of GDP; a 15 percent benefit reduction targeted to higher pensions could yield another 1.2 percent of GDP in savings; providing full indexation only to lower pensions and partial indexation to higher pensions (average indexation 50 percent) could yield another 0.8 percent of GDP—combined reduction 5.5 percentage points of GDP by 2030 versus no-reform baseline.
  - An increase in social contributions by 3 percentage points would yield about 1.3 percentage points of GDP in savings; such an increase would keep total contribution rates below levels observed in Italy.
- Policy guidance and caveats:
  - Further parametric reforms should be assessed through a careful actuarial review as part of ongoing policy discussions.
  - Potential reforms under discussion include: increase in retirement age, transition to a defined contribution system, and incentives for complementary pensions.
  - The simplified projections are illustrative and not a substitute for detailed actuarial analysis; more detailed pension fund projections will be needed to ensure reforms achieve fiscal and financial stability.

*Source: IMF staff.*

### 6.8 percent overall.

### 1smrea2019001 - 6.8 percent overall.

### Projected Pension Spending and Reform Scenarios
- Projected pension spending (baseline projection) shown for years 2016, 2017, 2020, 2030, 2050 (figure labels present).
- Reform scenarios illustrated (labels retained):
  - Retirement Age Increase (3 years)
  - Benefit reduction (15 percent)
  - Indexation of benefits (50 percent of cost of living)
  - Increase in Payroll Taxes
- Reduction in Benefits and Increase in Retirement Age trade-off points shown: 18.2, 13.7, 9.1, 4.6, 0.0 (values from plotted points under "Reduction in Benefits (in percent)" vs "Increase in Retirement Age (in years)").

### Public Pension Systems and Demographic Indicators (selected figures from Table A6.1)
- Benefit ratio, statutory retirement ages (male/female, early retirement ages in parentheses), dependency ratio, and coverage ratio are presented for selected European countries. Selected exact entries:
  - San Marino: Benefit Ratio 70.9; Male statutory retirement age 65.6 (60); Female statutory retirement age 65.6 (60); Dependency ratio 29.7; Coverage ratio 136.9
  - Austria: Benefit Ratio 50.5; Male 65 (60); Female 60 (55); Dependency ratio 27.6; Coverage ratio 146.8
  - Belgium: Benefit Ratio 41.8; Male 65 (62); Female 65 (62); Dependency ratio 28.4; Coverage ratio 134.2
  - France: Benefit Ratio 50.5; Male 66.3 (61.3); Female 66.3 (61.3); Dependency ratio 30.4; Coverage ratio 152.9
  - Germany: Benefit Ratio 42; Male 65.5 (63); Female 65.5 (63); Dependency ratio 32.2; Coverage ratio 129.6
  - Italy: Benefit Ratio 58.9; Male 66.6 (63.6); Female 66.6 (63.6); Dependency ratio 34.5; Coverage ratio 112.1
  - Malta: Benefit Ratio 49.2; Male 62 (61); Female 62 (61); Dependency ratio 29.1; Coverage ratio 101.5
  - Netherlands: Benefit Ratio 35.7; Male 65.5 (65.5); Female 65.5 (65.5); Dependency ratio 28.1; Coverage ratio 129.3
  - Spain: Benefit Ratio 57.7; Male 65.3 (63); Female 65.3 (63); Dependency ratio 28.6; Coverage ratio 108.1
  - Sweden: Benefit Ratio 38.6; Male 67 (61); Female 67 (61); Dependency ratio 31.6; Coverage ratio 127.3
  - United Kingdom: Benefit Ratio 27.8; Male 65.4 (65.4); Female 63.1 (63.1); Dependency ratio 27.9; Coverage ratio 111.6
- Sources: EU Commission, Sammarinese authorities, and IMF staff calculations.

### San Marino: Social Security Spending and Structure (Box A6.1)
- The Institute for Social Security (ISS) manages social security; financed partly by the central government.
- ISS spending groups: healthcare, temporary benefits, pensions.
- Healthcare and pensions account for more than 85 percent of total spending.
- Temporary benefits include family allowances, unemployment-related benefits, and compensations for occupational sickness and injuries.
- As of end-2017, spending on social security totaled €295 mill. (21 percent of GDP).
- Comparative observations:
  - San Marino spends relatively less than the EU average on healthcare and other benefits.
  - Spending on pension is close to the EU average.
  - In relative terms, San Marino spends a higher amount on pensions compared to the rest of the EU by almost ten percentage points, a level similar to Italy and Cyprus.

### Pension Reform Proposals under Discussion (Box A6.2)
- The government has advanced the following proposals (draft reform not yet available):
  - Increase in retirement age. A minimum retirement age of 63 years with 40 years of contributions (“Quota 103”) for early retirement and an increase in statutory retirement age to 67 years for old-age pensions.
  - Defined contribution. The introduction of a defined contribution mechanism based on actuarially fair rules.
  - Automatic adjustment. The retirement age would be automatically linked to life-expectancy.
  - Part-time retirement. The mechanism would enable workers approaching retirement age to reduce their working hours and to be granted an early partial seniority pension.
  - Working in retirement. Retirees benefitting from old-age pension would be allowed to continue to work and pay into the pension funds.
  - Means-testing. The minimum pensions would satisfy a means-test.
  - Expanding complementary pensions. The proposals intend to incentivize the use of complementary pension systems. These include increasing the deductibility of contributions paid by employers and workers and governance reforms to improve investment rules which provide inadequate returns.

### Fiscal and Economic Context (selected staff report highlights)
- Economic growth slowed in 2017; expected to recover in 2018 at a moderate pace of around 1.1 percent.
- Unemployment: peaked at 10 percent in early 2016; declined to around 8 percent subsequently.
- Employment gains: 4 percent in the private sector with respect to 2017, mostly for cross-border workers.
- Infrastructure and reform actions noted:
  - A 5G telecom network expected to be ready by the end of 2019.
  - Association agreement with the EU could be finalized before the end of 2019 (announced at the high-level meeting held on March 5th and 6th in Brussels).
  - Signing of a Memorandum of Understanding with the Bank of Italy in prospect.
- Authorities’ fiscal note: overall fiscal deficit is projected to have narrowed in 2018 by about 1 percentage point.

### Financial Sector and Policy Priorities (staff and authorities’ views)
- Authorities and staff agree on urgency to repair banking system, strengthen banks’ liquidity and capital, and advance NPL resolution.
- Government commitment to support CBSM role in Financial Sector Strategy: recapitalization (following AQR results), organizational and governance restructuring, and NPL reduction.
- Authorities’ concerns and positions:
  - Disagree with staff’s inclusion of tax credits in implicit public debt calculations; view tax credits as public debt only if converted into government bonds.
  - Major concerns on staff’s suggestion to apply burden sharing, including to subordinated debt, given San Marino’s specificities.
  - Consider full guarantee of the Institute of Social Security’s (ISS) pension deposits necessary to boost confidence and relieve liquidity pressures.
- Regulatory and supervisory improvements highlighted:
  - Enhance CBSM supervisory powers and bank resolution framework.
  - Remove legal, regulatory, and tax impediments to NPL resolution.
  - Improve banks’ efficiency: reduce operational costs (including labor) and rationalize branch network.
  - Strengthen AML/CFT legal and regulatory frameworks; transposition of 4th EU AML Directive into national law noted.
  - OECD Global Forum upgraded San Marino’s rating from “Largely Compliant” to “Compliant” on Exchange of Information on Request.

*Source: REPUBLIC OF SAN MARINO — STAFF REPORT FOR THE 2019 ARTICLE IV CONSULTATION—INFORMATIONAL ANNEX (Prepared By European Department, March 5, 2019; Statement by Domenico Fanizza and Francesco Spadafora, March 22, 2019).*

### 2.7 percent of GDP—on the back of adopted one-off measures.

### 2.7 percent of GDP—on the back of adopted one-off measures.

### Fiscal stance and 2019 budget
- The 2019 budget approved in December 2018 aims at achieving a broadly balanced position, net of government transfers to CRSM.
- The budget introduces new measures, which are projected to partly offset the measures expired in 2018.
- Authorities agree that an ambitious fiscal adjustment, with measures on both the revenue and expenditure side, is needed to:
  - put public debt on a sustainable path, and
  - gradually build fiscal buffers.
- Planned tax reform: replace the single-stage import tax (Monofase) with a value-added tax (VAT) in 2020 to remove distortions and yield additional revenues.
- Political economy: authorities note the challenging political environment and the need to achieve broad agreement with social partners to ensure successful implementation of indirect taxation and pension reforms.

### Pension and social protection reforms
- Authorities are finalizing a pension reform aimed at:
  - containing transfers to the ISS,
  - safeguarding the pension system’s sustainability, and
  - achieving budget savings.
- Elements of the pension reform include the postponement of the retirement age and the transition to a more sustainable system of pension calculation.
- Development of a household wealth indicator to:
  - facilitate better targeting of social benefits, and
  - strengthen the ISS financial standing.

### Health sector and spending efficiency
- Health sector principle: universal coverage.
- Planned shift to a new approach based on prevention and enhanced monitoring to set health expenditure on a more moderate rising trend.
- Authorities are conducting a spending review to improve efficiency across government units.

### Structural reforms and labor market policies
- Objectives: internationalize and diversify the economy; tackle structural impediments to faster growth.
- Noted improvements: San Marino’s Doing Business score in recent years; role of the Development Law in supporting employment.
- Established the Office for Active Labor Market Policies to enhance training and job searching and better target social benefits.
- An Economic Development Agency has been recently set up to promote foreign direct investments and tourism.
- Authorities emphasize support for higher private investment through:
  - alleviating firms’ loan interest payments,
  - expanding tax incentives,
  - reducing red tape, and
  - utilizing public-private partnerships.

### Infrastructure, integration, and growth strategy
- Investments made to upgrade infrastructure in telecommunication and improved transportation to increase business connectivity and competitiveness.
- Anticipated benefits from conclusion of the Association Agreement with the EU, including simplification of operations of Sammarinese firms abroad.
- Authorities believe San Marino has unexploited growth potential and are seeking financial partners to support infrastructural and innovative projects and contribute to upgrading the industrial and financial sectors; discussions are ongoing with several interested parties.
- Government initiative to promote a reflection on the future of the Sammarinese economy to support sustainable and equitable growth; the initiative will engage civil society and representatives of main productive sectors and will be launched in the coming weeks.

### Technical assistance and statistics
- Authorities acknowledge Fund technical assistance that has greatly improved the production of statistics on the balance of payment and International Investment position.

*Source: 1smrea2019001 - 2.7 percent of GDP—on the back of adopted one-off measures.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1smrea2019001.pdf_