Mission Concluding Statement 

San Marino: Staff Concluding Statement of the 2023 Article IV Mission

September 28, 2023

San Marino’s strong economic performance continues amid external shocks and a weakening European economy. Activity has been supported by a competitive manufacturing sector and booming tourism that has exceeded pre-covid levels. However, weakening external demand and tighter international financial conditions will affect growth going forward. Ensuring healthy fiscal and financial sector buffers is key to preserve stability and confidence in a euroized economy like San Marino. In particular, the recent improvement in the fiscal position should be consolidated and expanded. Also, further efforts are needed to address high nonperforming loans and strengthen banks’ capitalization and profitability.

The nonfinancial sector recovery that started in 2014, placed the Sammarinese economy in a strong position to face the shocks in the last few years. The global financial crisis and international efforts to address preferential tax regimes triggered a major crisis that ended San Marino’s banking business model. The banking crisis had major spillovers on the nonfinancial sector that were magnified by the blacklisting of San Marino as a jurisdiction with a preferential tax regime by the Italian authorities during 2010-14. While the contribution of the financial sector to activity never recovered, the nonfinancial sector started a recovery in 2014 underpinned by cost-competitiveness in labor, strong balance sheets and access to Italian banks. Thus, San Marino’s exporting sector was in a strong and competitive position when the pandemic hit, contributing to its remarkable resilience during this period and its strong subsequent recovery that continues today.

Despite external shocks and higher interest rates, growth has remained resilient in San Marino and supported a tight labor market with full employment. Prudent policies and access to international capital markets, increased policy buffers to healthy levels. Robust external demand until recently boosted manufacturing and the tourism sector. With the economy booming, employment reached record levels. The recovery has so far been resilient to headwinds from higher inflation, tightening financial condition and weak external demand. However, these factors and heightened global uncertainty will weigh on activity that is expected to slow down. Inflation is forecasted to remain elevated but declining in line with Italian trends.

The successful Eurobond rollover in May 2023 significantly reduced short-term risks improving domestic liquidity and supporting confidence . Downside risks relate to the weakening of external conditions, and further global monetary tightening while domestic risks concentrate on political uncertainty due to elections next year and remaining vulnerabilities in the financial sector. The underlying strength of the manufacturing sector and healthy private sector balance sheets provide some upside risks to the baseline.

The fiscal position has improved in recent years, but further efforts are needed to consolidate these gains and ensure sustainability. The government has appropriately saved inflation revenue windfalls and prudently indexed public sector wages and pensions below inflation containing expenditures pressures. However, San Marino is a euroized small open economy, with a vulnerable financial sector and limited fiscal buffers. Thus, further fiscal consolidation going forward remains critical. In this connection, San Marino should target a level of public debt below 60 percent of GDP. This goal, consistent with the EU framework, provides an anchor for fiscal policy that will ensure sustainability. To achieve this target by 2028, a moderate fiscal effort of 1 percent of GDP over the next three years is needed through:

• Revenues mobilization. There is room to reduce income tax exemptions, introduce a Value Added Tax, reduce the discounts on petroleum products and expand the use of excise duties that would raise revenue and help address environmental externalities.
• Spending consolidation. Prudent wage and pension indexation will further contain expenditure while inflation remains elevated. In addition, it is key to improve spending efficiency by performing spending reviews across all public sectors.

The pension reform approved last year stabilizes the pension system deficit over the medium-term, but long-term demographic challenges persist. The reform delays the depletion of pension-fund assets by a decade by increasing contributions. However, the long-term sustainability of the pension system requires a complementary parametric reform focused on addressing the challenges due to an aging population, generous benefits, and low penalties for early retirement.

To strengthen the fiscal policy framework and provide predictability, there is a need to develop and communicate a medium-term fiscal strategy. This strategy should provide a medium-term perspective of fiscal policy and its impact on debt sustainability. In addition, a complementary medium-term debt strategy identifying medium-term financing needs should be developed. It should aim at maintaining healthy levels of liquidity while minimizing both rollover risks—including, if feasible, through liability management operations to smooth the large amortizations in 2027—and financing costs.

Banks’ profitability has improved supported by higher interest margins, but higher interest rates also bring risks. With nonperforming loans (NPLs) at 56 percent (28 percent net of provisions), high operational costs and tight capitalization in some banks (above the regulatory requirements), the financial sector remains vulnerable. In line with the experience in most countries in Europe, higher interest rates have been passed to borrowers faster than to depositors. This has supported profitability, but it has also brought risks to the financial sector as, among other things, it deteriorates borrowers’ repayment capacity. However, a robust labor market and full employment have prevented a deterioration of the quality of the lending portfolio characterized by mostly variable-rate loans.

Further efforts are needed to improve banks’ profitability and capitalization. Looking ahead, with increasing deposit rates, interest margins will decrease impacting profitability. At the same time, weaker economic activity going forward can deteriorate loan quality. Thus, banks should use profits this year to increase capital and should support future profitability by restarting efforts to reduce high operational costs that have stalled over the last year.

There has been significant progress in implementing the authorities’ strategy to reduce NPLs through an Asset Management Company (AMC) and calendar provisioning. An AMC, which will securitize part of the stock of NPLs, aims to resolve NPLs more efficiently taking advantage of economies of scale. The international placement of the senior tranche of the securitization, based on an external valuation of the NPL portfolio transferred to the AMC, will provide fresh liquidity to banks that could support profitability going forward. After the appointment of reputable international firms with expertise in this area as arrangers and servicers, operational work to launch the securitization is advancing—the valuation of NPLs to be transferred is almost completed—and could be concluded before the end of the year. Introducing a realistic sunset clause for the AMC will be important to limit political interference and reduce implementation risks. NPLs remaining on banks books will be subject to phased-in recognition of potential past losses (calendar provisioning). Any undercapitalization that could arise from the securitization process and the implementation of calendar provisioning should be promptly addressed with credible capitalization plans. The intention to establish the government guarantee below expected recovery values is welcome as it minimizes fiscal risks.

The bank resolution framework needs to be enhanced and aligned with European standards . The reform of 2019 failed to fully conform to the European framework. At the same time, limits on banks’ shareholding structure should be lifted.

The CBSM financial position should be strengthened to safeguard its independence and support financial sector stability through an effective lender of last resort capacity . In a euroized economy without independent monetary policy, preserving healthy levels of financial sector liquidity buffers is key to support stability and confidence. International reserves have fallen as banks’ deposits moved abroad seeking higher yields but have stabilized since end 2022. To ensure the CBSM has enough capacity as a lender of last resort, reserve requirements ratio should be gradually increased. At the same time, a strong CBSM financial position is also critical to perform this role and consolidate recent supervisory initiatives. Furthermore, adopting the European financial sector framework in the context of the EU Association Agreement will impose potentially significant compliance costs on the CBSM that will have to be addressed.

San Marino should continue to make progress to strengthen the implementation of the AML/CFT framework . The AML/CFT assessment report by MONEVYAL indicated satisfying levels of effectiveness in many areas but highlighted some areas where further efforts are needed including supervision, preventive measures (i.e., customer due diligence), transparency of legal persons and legal arrangements, money laundering investigations, and targeted financial sanctions for terrorism and proliferation financing. Taking this into account, the authorities are in the process of transposing the EU’s 5 ^th AML directive into the domestic legal framework. San Marino has demonstrated successful efforts in cases of asset confiscation.

Structural reforms are critical to support the competitiveness of the manufacturing sector and consolidate recent gains in tourism boosting the growth potential of San Marino . The Association Agreement with the EU will boost economic integration reducing transaction costs and attract foreign investment. Recent labor market reforms have increased flexibility by liberalizing cross-border work arrangements. However, further liberalization is needed by lifting disincentives on fixed-term contracts and make temporary contracts in line with the Italian framework. Finally, upgrading the outdated insolvency and creditor rights framework will be key to address structural bottlenecks, increase investment and support NPL resolution.

The mission would like to thank the authorities and other counterparts for their warm hospitality as well as open and productive discussions.