Public Information Notice No. 99/22

Public Information Notice: IMF Concludes Article IV Consultation with San Marino

March 11, 1999

On February 25, 1999, the Executive Board concluded the Article IV consultation with San Marino¹.

Background

Throughout most of the last decade, the Sammarinese economy has displayed an enviable growth performance, further developing niche positions based on comparative and tax-induced advantages. Output and employment growth remain robust, and the unemployment rate remains enviably low. Inflation has fallen in line with that in Italy. However, the fiscal accounts, in contrast to their traditional small surpluses, have recorded deficits in 1996–97, with a resulting reduction in net government deposits.

Real GDP growth slowed somewhat from the pace at the beginning of the decade, and expanded by 5 percent per annum during 1996–97. Employment growth slowed during 1995–96, rebounded to 3.3 percent in 1997, and accelerated to 3.8 percent over the 12 months through September 1998, with an increasing number of cross-border workers, who now constitute more than 20 percent of total employment. Many of the newly created lesser-skilled jobs have been filled by cross-border workers, while unemployed Sammarinese workers have waited for more remunerative positions, including in the public sector. The unemployment rate fell to a seasonally unadjusted 3.8 percent in September 1998. Real wage gains accelerated to an average of 5.9 percent per annum over 1996–97. Inflation fell sharply in 1997 to 2 percent, mirroring the decline in Italy; these favorable developments continued in the first nine months of 1998.

Prior to 1999, San Marino maintained a currency union with Italy, with the Italian lira circulating as legal tender in San Marino. On January 1, 1999, San Marino adopted the euro.

San Marino’s tradition of prudent fiscal policy has enabled the government to impose generally low rates of taxation, while accumulating sizable bank deposits. However, the public finances have come under pressure in recent years, with cash-based budget deficits equivalent to 3.9 percent and 2.1 percent of GDP in 1996 and 1997, respectively. This reflected weak tax performance, continued hikes in the central administration wage bill and health care expenditures, a greater fiscal burden from targeted subsidies and tax exemptions, and an increase in capital expenditures, albeit from a low level. While cash-based data are not available for 1998, a further reduction in net government deposits equivalent to some 4 percent of GDP was recorded in the first half of 1998, the result of the implementation of a number of public investment projects and a more rapid payment of some government obligations than in the past. In contrast, government deposits rebounded slightly (by ½ percent of GDP) in the third quarter of the year.

The Sammarinese authorities have already introduced a number of corrective fiscal measures. They have imposed a hiring freeze on government employment. The 1999 budget contained a 5 percent cut in all discretionary current expenditures. They began a thorough review of public sector activities, with a reform plan to be completed by October 1999, to enhance the flexibility of and to reduce government employment, and to increase the productivity and the quality of public services. They have also adopted in 1998 a new Budget Accounting Law that should strengthen expenditure controls and improve program monitoring and evaluation. The government also intends to introduce reforms that would improve the financial stability of the health care and pension systems, in light anticipated demographic pressures.

The government has introduced a number of structural reforms that should liberalize and improve the flexibility of the labor market. These include the elimination of backward-looking wage indexation in the public sector in 1997. Labor retraining programs have been expanded and a labor market monitoring center has been established to collect and disseminate information to facilitate job matching.

San Marino’s financial sector, which has thrived under tax-induced advantages and bank secrecy, could come under increased competitive pressures from banks in surrounding regions, and possibly from pressures to further align San Marino’s tax and regulatory system, were progress to be made in tax harmonization in the EU.

Executive Board Assessment

Executive Directors observed that throughout most of the last decade, the Sammarinese economy has displayed an enviable growth performance, resulting in a per capita income in excess of that of most other European economies. This can be attributed to a number of factors. A stable political and legal structure and prudent fiscal policies, including low tax rates, have provided fertile ground for productive investments. San Marino’s well-educated labor force has adapted smoothly to the evolving pattern of the economy’s comparative advantage. And, despite its small size, the economy’s broad diversity across manufacturing, tourism, and other services has served to cushion it in the face of external shocks.

Directors welcomed the new government’s resolve to reverse the recent deterioration in the fiscal accounts. This worsening has been the result of weak indirect tax performance, continued increases in government employment and the wage bill, a greater fiscal burden from targeted subsidies and tax exemptions, and higher capital spending. They concurred that the authorities are correctly emphasizing reductions in current expenditures, as this would maintain the economy’s low tax environment while allowing for necessary improvements in public infrastructure. Among those reductions, the hiring freeze will provide a short-term remedy, to be replaced by reforms in the scope and scale of government operations that should be contained in the forthcoming public sector reform. The new Budget Accounting Law should also improve expenditure monitoring and control, and the new information system should allow for better program evaluation and improve efficiency. Directors noted that San Marino relies on tax preferences and subsidies to promote targeted economic activities to a greater degree than other European countries. The fiscal costs of these policies, including tax expenditures, should be made transparent in the budget. The government should consider, however, that it may be able to achieve its objectives at a lower cost by using other policy instruments. Directors suggested that economic growth could be facilitated by the provision of adequate public infrastructure that would provide more support for higher value-added activities, strengthen labor force retraining, or lower basic tax rates for all activities.

Executive Directors endorsed as appropriate the authorities’ medium-term goal of rebuilding government deposits after their recent decline in light of the openness of the economy and its small size relative to potential external shocks, as well as prospective demographic pressures. Maintaining deposits at a constant share of GDP over the business cycle would allow for automatic stabilizers to operate, while ensuring that an adequate cushion remains available to address the potential costs of external shocks. They thought that achieving this goal is important in light of prospective financial pressures on the health care and pension systems that will emerge as the population ages. Efforts to increase utilization of domestic health care facilities through arrangements with surrounding regions, and possible public/private cooperation in some areas, have potential benefits and should be explored. However, continued free and universal health care may only continue to be feasible with increased contribution rates. Directors observed that consideration could instead be given to introducing selected fees and co-payments, which should also aid in rationalizing the use of medical services. They thought that renewed interest regarding pension reforms is timely and welcome. Introducing a fully funded pillar for new labor market entrants is aided by the government’s net asset position and would improve efficiency and intergenerational equity. Nevertheless, thebasic parameters of the existing system would have to be adjusted to ensure its financial soundness. Thus, Directors concluded that it would be useful to begin these reforms as soon as feasible, given the long time period necessary for their implementation.

Executive Directors were of the view that the economy’s performance could be enhanced by further strengthening efforts to improve the flexibility of factor and product markets. They welcomed the elimination of backward-looking wage indexation, as it has increased real wage flexibility. It will be essential that the government vigorously pursue its plans to reform the public administration and reduce public sector employment, so as to curtail "wait unemployment" and improve the allocation of labor across the economy. Liberalization of the use of temporary employment should also enhance labor flexibility. Efforts to improve the matching of labor skills through the planned high school, broader access to labor market retraining, and liberalization of the employment list system are also welcome. Additional information through the government’s labor market monitoring center should improve the market’s functioning, but could be further enhanced through private sector job placement services. Efforts to streamline the business licensing system should also further the economy’s dynamism.

Directors noted that San Marino’s financial sector appears to be more than adequately capitalized and quite profitable, but faces a number of challenges. Adoption of the euro, and the anticipated implementation of the Finance and Exchange Agreement with Italy, should provide new opportunities for the Sammarinese economy and reduce transaction and financial costs. However, likely improvements in the efficiency of the Italian banking system could intensify competition, and there may be strong pressures to more closely align Sammarinese taxes and regulations with those of the EU. The supervisory system will need to be adapted and strengthened to ensure the soundness of a financial system that is expected to offer increasingly sophisticated products and services, possibly including an insurance sector. Moreover, efforts should be made to adopt standard benchmarks that are internationally comparable and to adopt the Basle Core Principles for Effective Bank Supervision.

Directors welcomed the authorities’ efforts to implement the recommendations of the STA multi-sector mission. While several improvements to the statistical system have been introduced or are anticipated in the near future (especially regarding monetary and fiscal data), a number of deficiencies remain regarding the quality, availability and timeliness of some basic data, that undermine informed policymaking and hamper effective Fund surveillance. It is crucial to ensure that sufficient resources are devoted to undertaking the necessary improvements expeditiously in this area, while paying due regard to the special features relating to the economy’s size.

Directors urged the authorities to consent to the increase proposed under the eleventh review of quotas and to accept the proposed fourth amendment of the Articles of Agreement.