San Marino -- 2006 Article IV Consultation Preliminary Conclusions

December 15, 2006

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.

December 11, 2006

1. San Marino has been undergoing a profound transformation. It has come a long way since the early part of this decade when growth was sputtering, public finances were precarious and the economy was mired in old-fashioned modus operandi. Responding to global competition, San Marino has begun reinventing itself into a more dynamic economy by modernizing its laws and regulations, and opening itself to new opportunities for growth. At the same time, it is experiencing the economic realities of an ageing population and has started taking action on several fronts to ensure that there are enough savings to make good on the promise of generous entitlements to its residents.

2. Reforms have already begun to yield dividends and macroeconomic conditions can be expected to remain benign in the near future. There is every reason to expect that, barring unforeseen circumstances, output will continue to grow at some 5 percent in 2006-07. The government has successfully contained its spending, especially on the wage bill and health care, built up its assets, and contained indebtedness. Reflecting the healthy economy and an increase in international deposits, the financial sector appears profitable, liquid and well capitalized. Efforts to improve supervision are beginning to bear fruit.

3. It is widely accepted that reforms need to continue. Most economic agents understand that the future of San Marino lies in the higher value-added service sectors, and that the traditional sectors must be given the opportunity to adjust nimbly in response to the changing global environment. Given its small size and location, San Marino remains especially vulnerable to international developments, in particular, changes in policies within Italy and Europe. Thus far, the highly open nature and relative flexibility of its economy and institutions have allowed San Marino to adjust quickly to changing circumstances. However, adjusting to shocks will be more challenging in the future, now that the traditional sectors of growth are declining in relative importance, and given that it will take time for the financial sector and other activities to emerge as alternative engines for growth.

4. Looking ahead, the main issue is whether San Marino is prepared to continue to embrace change and equip itself to participate effectively in the global market, which is increasingly knowledge- and technology-driven. Economic agents are clamoring to break free from the stranglehold of an inflexible labor market. They demand clarity in the terms of economic engagement with Italy, especially with regard to taxation; a quick modernization of the regulatory framework so that international markets can become more accessible; and greater efforts to improve the image of San Marino abroad so as to be better able to attract businesses, tourists, and high-skilled workers. Policymakers are aware of these needs, and have started taking measures in some areas.

Against this background, policymakers would need to act in the following main areas:

Public finances

5. In designing fiscal policy, the government has the difficult task of balancing the twin objectives of preserving competitiveness while ensuring sustainability. On the one hand, tax rates have to stay low to attract businesses and commuters. On the other hand, public finances are vulnerable to fluctuations in revenues due to the mobility of factors of production in response to policy changes in Italy, while remaining responsible for the expenditure commitments arising from the generous entitlement policies. These challenges are evident in the budget outturn for 2006 which, despite the success in controlling current spending, is likely to have a lower surplus than in previous years, partly because of the impact of lower tax rates. This balancing act is made more difficult by the need to prop up the finances of some public enterprises because tariffs fail to adjust even as raw material costs increase world wide.

6. In 2007, public finances will face even more binding constraints. Corporate tax rates will be lowered once again to preserve competitiveness and attract businesses, while the government will need to make necessary infrastructure investments that are vital to support growth. In addition, it will have to continue making transfers to public enterprises and the social security fund to enable them to meet their expenditure obligations. The overall budget balance will likely swing into a deficit, forcing the government to take on more debt and draw down its reserves. Given the limited scope for maneuver on tax rates, a further expansion of the tax base would be necessary if the tax cut is to be revenue neutral. Current spending will need to be further curtailed, particularly by reducing transfers to public enterprises by allowing them to operate as viable commercial enterprises. To this end, plans to allow tariffs to automatically adjust to reflect market conditions are a step in the right direction.

7. If anything, the constraints on public finances will become even more binding over the medium-term as the population ages. The government's ambitious pension reform program intends to address this looming problem and compares favorably with reforms enacted elsewhere. Nevertheless, actuarial calculations suggest that even these reforms will fail to wean the pension fund from steady and increasing budget transfers for the foreseeable future. Given the constraints on the revenue side, there may be a need to introduce further changes in the pension system parameters to ensure that adequate funds are available without recourse to increasing budget transfers. In this regard, plans to regularly update actuarial calculations to better monitor sustainability, improvements in the management of the social security fund, and the streamlining and consolidation of pension funds for "non-dependent" categories of workers, should help the government better control spending. A mandatory defined-contributions second pillar would bolster the private sectors' own efforts to save for retirement, and the government's intention to put such a system in place is welcome. Improvements in the labor market could also be considered as a way to boost the deteriorating ratio of workers to retirees. The ageing population will also put pressure on health care spending. Even with the cuts made so far, San Marino continues to spend more on its health care than almost every country in Europe. It is therefore time to consider demand-side measures to further restrict spending on health care, such as the introduction of co-payments and a broad use of generics.

8. More generally, it would be worth considering the establishment of a rules-based mechanism to minimize the pressures on public finances arising from risks on the revenue side and high spending commitments. Ideally, the rule would seek to ensure that the consolidated government's net reserves every year are sufficient to cover its forthcoming nonreversible spending commitments, just in case revenues fall short due to reasons beyond the government's control. It is too early to determine the specifics of this rule. However, preliminary calculations suggest that the consolidated government may need to run surpluses in the range of 1½ -2 percent of GDP a year if, for example, it is to build sufficient reserves by the end of the decade to have an adequate cover for its commitments on social spending. Planned improvements in the budget accounting framework to better capture an accurate picture of fiscal developments should also be useful in this regard.

Financial sector stability and development

9. The financial sector is undergoing a quiet revolution. Always a significant contributor to budget revenues, in recent years, it has also become an increasingly important contributor to growth, and there is a general recognition that the development of this sector will be vital for the future of the economy. A slew of reforms have been put in place within a short span of time, ranging from the delegation of the task of supervision to the central bank and the building of firewalls between the supervisory arm and the Board to prevent regulatory forbearance, to the gradual modernization of the regulatory framework. In-depth offsite and onsite supervision of financial institutions have been initiated. All this is an impressive feat given the limited resources at the disposal of the central bank.

10. The key task now will be to manage this transition and allow the central bank the necessary room to implement these laws in an arms-length manner. Every effort should be made to ensure that the central bank's independence is not compromised by pressures from vested interests, especially in the areas of licensing, supervision, and extraordinary administration of problem institutions. Greater autonomy in the financing of the central bank's budget would be a step in this direction. In addition, supervisory resources should be further increased to ensure that the initial round of on- and offsite supervision can be completed quickly and, thereafter, be performed at regular intervals.

11. The financial sector appears to be adapting well to changes emanating domestically and from the international environment. The withholding tax on interest income has not affected banks' balance sheets yet, as Sammarinese banks remain competitive at the rates applicable at the initial stage. Nevertheless, banks are bracing for the impact of planned increases in the tax rate further down the road. While bank secrecy, simpler procedures and the speed of response will continue to provide a comparative advantage, Sammarinese banks are diversifying into more sophisticated products and other markets in order to counter the impact of the increase in the tax rate. Similarly, non-bank financial institutions are gearing up to benefit from the new laws by getting into the mutual funds business. The extent of transformation of the financial sector will, to some extent, depend on its ability to persuade traditional customers to assume greater risks, and to attract a broader clientele. Nevertheless, clearly the financial sector is venturing into lines of businesses, products, and clients where it has less experience. It is also clear that some institutions are less prepared than others to successfully undertake this transition as is already evident in the variance in capitalization and credit quality across institutions.

12. It is therefore imperative for the central bank to closely monitor the developments in the financial system through greater oversight. The planned improvements in banks' reporting requirements to the central bank must be quickly implemented. There is a need to ensure that banks and their clients are aware of the risks involved in the new lines of business through strengthened transparency and disclosure, and that the financial institutions are equipped to assess and manage their own risks. The central bank's efforts to cooperate closely with other supervisory authorities should facilitate cross-border exchange of information, consolidated supervision, and improvements in business practices. Deposit insurance—which is on the policy agenda—should be introduced only after supervision capacity has been sufficiently improved. We welcome the authorities' decision to participate in the IMF's Financial Sector Assessment Program which will take a closer look at these issues.

Labor market reforms

13. As San Marino seeks to diversify and modernize its economy, its labor market would need to adjust accordingly. Several useful steps have already been taken to improve flexibility, such as the lengthening of fixed-term contracts, simplification of hiring procedures and incentives to improve training. These initiatives might help upgrade workers' skills for the traditional sectors of the economy, but are unlikely to be sufficient for attracting the level and types of skilled workers required for the tertiary sector.

14. The economy is running up against capacity constraints for growth because of its difficulty in hiring the highly-skilled labor force that it needs to compete effectively in a global economy. This is specially true in the service sectors where the need for skilled labor is paramount. The constraints are manifold, such as:

• Lengthy procedures to hire non-resident workers because of the need to establish the unavailability of the required skills from among residents currently listed as unemployed. Plans to ease some of these restrictions by 2011 are too little and will come too late;

• Restrictions on the length of work contracts that can be offered to non-residents make it difficult to attract the best qualified workers at a time when the competition for skilled labor is global and stiff;

• Uncertainties regarding the tax treatment of commuter workers from Italy;

• The lack of a regulatory framework to facilitate outsourcing; and;

• Restrictions on residency, which is a deterrent for attracting skilled labor from further afield.

In addition, the incentives to promote active labor market policies are not well designed: they are costly to the budget; they do not have the buy-in of the labor force as they entail temporary income losses; and they are ripe for abuse by firms which could avail themselves of these facilities merely to reduce costs rather than improve workers' productivity. The incentive structure for active labor market policies would therefore need a re-think.

Business Climate

15. San Marino is trying to improve its business climate rapidly. The new corporate law consolidates various rules of operation into one document and seeks to improve corporate governance. The new financial sector regulations seek to do the same in the financial sector, and the supervisors are actively keeping an eye on the internal controls and management of financial institutions. The tax burden is being reduced through lower rates; greater clarity in tax liabilities through double taxation agreements with various countries; a faster resolution of backlogs in tax liabilities; and simpler procedures for tax payments. Plans to improve public administration and services are afoot with the intention to make it easier for businesses to comply with regulations.

16. Given the rapid changes in the global economy, improvements in the business climate are, by necessity, a work in progress. The existing initiatives are in their early stages and would need to be continually improved on the basis of lessons that emerge during implementation. The most important remaining challenges are to finalize the agreement with Italy, and to finish upgrading the laws of the country to ensure full compliance with international anti-money laundering provisions.


17. While important improvements have been made in compilation, the time lag in producing statistics should be reduced and dissemination improved. San Marino has recently started producing fiscal accounts, and monetary and financial sector data according to international standards and has started publishing these data via the IMF. Nevertheless, some key statistics are available with long lags, and dissemination practices are behind times. These deficiencies hurt San Marino's efforts to reach broader markets, while increasing the risk that the policymakers may be blind-sided by unexpected developments. We welcome the authorities' intention to participate in the General Data Dissemination Standards and the IMF is ready to assist them in this process.

We would like to thank the authorities for the fruitful discussions and their warm hospitality.

We wish them success in their endeavors.


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