Public Information Notice No. 04/82

Public Information Notice: IMF Concludes 2004 Article IV Consultation with San Marino

August 4, 2004

On July 28, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with San Marino.¹

Background

Growth of San Marino's economy has slowed considerably since 2000 with the fading of competitive advantages that had contributed to past rapid development. In the period 2000-2002, GDP growth decelerated to an average of about 2.8 percent, about one-third the pace achieved in the 1990s and below the growth rates of other small European countries over the last three years. Manufacturing and commerce faltered in the midst of inflexible labor markets, narrowing tax advantages, and greater price competition from nearby areas. In the financial sector, a flurry of new entrants, and the repatriation of Italian deposits in the wake of a tax amnesty, eroded profitability. Against this background, GDP is expected to rise by 2 percent in 2004, after stagnating in 2003.

After years of recurrent fiscal deficits, the government achieved a surplus of about 1.5 percent of GDP in 2003 owing to cutbacks in public sector employment, moderate growth in public sector wages, and better administration of indirect taxes. As a result, the net asset position of the central government—which had deteriorated by more than 15 percent of GDP in a decade—began to improve. For 2004, the carry-over effects of the 2003 adjustment and additional measures in the budget should allow an overperformance relative to the deficit target of a half percent of GDP. Despite this positive short-term outlook, slow revenue growth and rising social security spending are a source of concern over the medium term. Total revenues of the central government fell by about 7.5 percent of GDP from 1992 to 2003, while pension expenditure grew by about 3.8 percent of GDP over the same period.

Recent initiatives improved the functioning of the labor and product markets, although some rigidities remain. The reduction in the public sector wage bill eliminated a long-standing source of wage-drift and loss of competitiveness, while new regulations accelerated the procedures to authorize nonresidents' hiring.

In the financial sector, Sammarinese banks remain somewhat more efficient and better capitalized, and have fewer nonperforming loans, than comparators. A heightened competitive environment enhanced the quality of services offered, but also put pressure on profits. In view of these trends, the authorities' have started to revamp the financial sector's legislative and regulatory framework by adopting Basel I and merging the Istituto di Credito Sammarinese—the former central bank—and the Office of Bank Supervision. Parliament recently approved new provisions for Anti-Money Laundering and Combating the Financing of Terrorism to bring San Marino further in line with international standards.

Executive Board Assessment

They welcomed the indications that an economic recovery appears to be underway, and commended the government for its intention to pursue an ambitious reform agenda aimed at returning San Marino to a high growth path. They observed that important synergies could arise from maintaining a budget surplus, introducing a comprehensive reform of the pension system, eliminating residual labor and product market rigidities, and upgrading the regulatory and legislative framework of the financial sector.

Directors noted that, in the short run, the improved global outlook would benefit both San Marino and its main trading partners, creating conditions favorable to pressing ahead with reform plans. Foreign demand could be expected to drive a recovery in manufacturing and tourism, while an upward shift in interest rates should raise the profitability of the banking system. Directors nevertheless pointed to the taxation of Italian commuters—as a result of the introduction of a bilateral treaty between San Marino and Italy—and prospective EU-related changes in savings taxation as possible downside risks for employment and growth.

Directors commended the decisive fiscal correction of 2003 and encouraged the authorities to continue improving the net financial position of the central administration, within their overall objective of achieving budgets in balance or surplus over the medium term. This would ultimately restore the government's ability to buffer adverse external shocks. Achieving this goal would require further reductions in the public sector wage bill, supplemented by significant improvements in tax administration and a scaling back of generous entitlement programs. Directors welcomed the decision to eliminate substantial tax exemptions, but highlighted the importance of giving the tax collection agency access to financial information on non-complying taxpayers. Directors also praised the ongoing initiatives to improve public expenditure management. They welcomed also the recent administrative measures aimed at reducing costs in the public health system, and suggested that the government should stand ready to introduce monetary disincentives should these measures fail to curb the growing demand for health services.

Directors welcomed the authorities' intention to press ahead with a reform of the pension system. They observed that even if past high employment growth continued, generous benefits and population aging would lead to widening deficits and substantial increases in the public debt. Directors endorsed a comprehensive and far-reaching reform that would link pensions to social security contributions over the entire working life, thus reducing incentives to underreport incomes and improving the financial situation of those pension funds that had been in deficit for years. Some Directors saw scope for an even more ambitious reform, taking advantage of the substantial reserves for introducing a fully-funded system.

Directors called for a deepening of labor and product market reforms. A number of Directors noted that matching the enhanced labor market flexibility of neighboring Italian regions was key to continue attracting foreign investment. In this connection, they encouraged the authorities to introduce fixed-term contracts for Sammarinese workers and liberalize further rules governing the hiring of nonresidents. More generally, Directors urged the authorities to pursue with determination their stated goal of substituting rules for political discretion in key areas of economic activity.

Directors supported the authorities' efforts to upgrade the financial sector's legislative and regulatory framework with the aim of enhancing its competitiveness while safeguarding its soundness. They called for a quick approval of the law creating the new Central Bank of San Marino (CBSM), whose governance structure should ensure a stable source of financing, clear lines of accountability to Parliament, and operational independence from the government and the banking sector. Several Directors encouraged the government to take this opportunity to transfer the authority to license financial institutions to the CBSM.

Directors emphasized the importance of enhancing supervisory practices, with more frequent on-site inspections and vigorous enforcement of international standards. They welcomed the ongoing expansion of supervisory staff, which could help ensure that declining profitability did not lead to increased risk-taking by banks. Some Directors observed that the EU-related increase in withholding taxes would reduce the appeal of traditional banking and stressed that the CBSM needed to gear up for the broader range of services and products that would be offered. Directors welcomed San Marino's intention to request a Financial Sector Assessment Program and commended its commitment to counter money laundering and the financing of terrorism.

Directors welcomed the progress made in improving San Marino's statistical database, but expressed concern that important shortcomings remained. They encouraged the authorities to devote additional efforts to the compilation of timely national account statistics and general government accounts in line with Eurostat's European Standards of Accounts 95 methodology. Directors urged San Marino to move toward providing official development assistance in line with the UN-recommended target.