Mission Concluding Statement 

San Marino: Staff Concluding Statement of the 2022 Article IV Mission

October 7, 2022

San Marino’s economic performance has been remarkable over the last two years. However, higher energy prices —below neighboring countries— weakening external demand and tighter international financial conditions will affect growth going forward. This challenging context combined with the rollover of the Eurobond, calls for further building up of buffers. Preserving healthy levels of fiscal and financial sector buffers is key to preserve stability and confidence in a euroized economy like San Marino. In particular, an ambitious fiscal consolidation, and further efforts to address high nonperforming loans and improvements in banks’ capitalization should be approved and implemented without delay.

The Sammarinese economy has experienced robust growth with a tight labor market, increased confidence, and remarkable stability over the last two years. With growth projected at 8.3 percent for 2021, the strong momentum has been kept so far this year resulting in a level of economic activity significantly above pre-pandemic heights. Strong external demand boosted manufacturing and a rebound in tourism led to strong economic activity that combined with increased confidence, led to higher government and banking sector deposits and international reserves. In this context, employment reached the highest level in over a decade and the tight domestic labor market led the authorities to liberalize cross-border employment. At the same time, the banking sector experienced a continued deposit increase and improved liquidity, profitability, and capitalization.

With higher energy prices, tightening financial conditions, and growing global uncertainty, activity is expected to slow down. The energy price increases are eroding households’ real income and firms’ profit margins. Combined with weakening external demand, these developments are expected to contribute to a marked deceleration of economic activity and deterioration of the current account surplus and international reserves as the economy adjusts to the negative terms of trade shock. As activity slows down, fiscal revenues will be impacted while inflation can increase spending pressures adding to pre-existing fiscal challenges. Downside risks related to Russia’s invasion of Ukraine, particularly a further disruption of energy supplies in Europe, continue to dominate the outlook although the remarkable resilience of the economy in the last few years could provide some upside risk. In this connection, the cautious wage increases agreed in the recent collective bargaining agreement in the industrial sector will help preserve employment as the economy weakens, providing welcome flexibility to the labor market. The rollover of the Eurobond in early 2024 remains a risk.

The authorities’ response to high energy prices allows price signals to operate, supports vulnerable groups and mitigates the macroeconomic disruption. By a combination of a long-term gas contract signed last year and timely electricity contracts, complemented with hedging operations just before prices surged, San Marino was able to secure significantly lower gas and electricity import price increases than those in Europe for this year and next. This has allowed the authorities to adjust tariffs to cost recovery levels but well below neighboring countries, at minimum fiscal costs, avoiding the potentially disruptive macroeconomic impact associated with unprecedentedly large tariff increases. The authorities’ plans to pass-through import energy prices to consumers next year will continue to avoid fiscal costs and preserve the financial soundness of the state-owned utility company (AASS).

Increasing global interest rates, elevated public debt, and the Eurobond rollover in 2024, call for an ambitious path for fiscal policy notwithstanding weakening economic activity. With increased global financial uncertainty, the authorities should be ready to take advantage of favorable market conditions and rollover the Eurobond whenever the opportunity arises starting early next year. Strong economic activity so far this year has temporarily boosted revenues, while the impact of the energy crisis on the budget has been limited. Given the weakening outlook, the authorities should save revenue over-performance this year to build up government deposits while resisting spending pressures. Going forward, strengthening the fiscal position will require a fiscal adjustment by the central government of 2 percent of GDP over the next three years to reach a central government primary balance of 2.5 percent of GDP complemented by pension reform. In particular,

• Revenues. The proposed income tax law amendments should be promptly approved and be more ambitious in simplifying the system and reducing exemptions and loopholes. The delay in implementing it this year could leave San Marino in a vulnerable fiscal position with a debt path that is declining but not robust to most shocks. Furthermore, introducing a Value Added Tax should also be considered particularly in the context of closer EU integration. Finally, there is also room to improve revenues by repealing discounts on petroleum products and expanding the use of excise duties that would, at the same time, help address environmental externalities.
• Spending. Public sector wage and pension increase in line with recently agreed private sector collective bargaining agreements could contain expenditure permanently and support the needed fiscal consolidation in the near term. More broadly, further improvement in spending efficiency will be needed and spending review across all public sector units is essential to contain government spending. Finalizing the Public Financial Management reform will enhance control over public finances through better accounting, reporting and transparency.
• Pensions. The pension reform under parliamentary discussion, stabilizes the system’s deficit over the next decade but further recalibration of pension spending will be needed to ensure long-term sustainability. The approval of this reform, expected this year, is a key priority that cannot be delayed given increasing deficits of the Social Security. By increasing contribution rates, the reform reduces projected deficits and stabilizes pension fund assets in the near-term. However, in the absence of more ambitious measures to contain pension spending—linking the retirement age to life expectancy, increasing penalties for early retirement, and calculating benefits based on the entire career—deficits will reemerge requiring a depletion of pension fund assets. Finally, the current limit on government transfers to the Social Security should be preserved.

There is a need to develop a comprehensive debt management strategy that will support debt sustainability and help develop a domestic debt market over the medium-term. With limited fiscal space, San Marino needs a strong, medium-term debt management framework to reduce rollover risk and financial cost, that incorporates plans for international and domestic issuances, and increases predictability. Publishing a medium-term debt strategy, an issuance calendar and an annual public debt report will help in this regard. In this context, the conversion of ex-BNS uninsured depositors’ bonds will help develop the domestic debt market and reduce the burden on taxpayers. Importantly, it will also smooth financing needs in a challenging period.

Banks’ profitability and capitalization have improved, but significant challenges remain. In 2021, banks have achieved profitability for the first time since the Global Financial Crisis and their capital base was strengthened. However, with extraordinarily high nonperforming loans (NPLs) and the recent halt of efficiency improvements, profitability remains limited and fragile. In the context of falling bond valuations and weakening activity, new pressures on the capital base have arisen. The Central Bank of San Marino (CBSM) allowed banks to transfer assets from the trading to the investment portfolio that is held until maturity. The plan to report these operations transparently is welcome.

There has been a delay in the implementation of the strategy to reduce NPLs. NPLs tie up administrative resources and banks’ capital, limiting the capacity of new lending to support economic activity. An asset management company could create the economies of scale to address system wide NPLs more efficiently, while providing fresh liquidity to banks and the opportunity of having an external valuation of NPLs. However, the lack of implementation more than two years after having been designed, has delayed banks own NPL resolution. Progress has been made establishing the by-laws for the servicer, the supervisory framework for the treatment of vehicle assets received by banks, and pre-selecting reputable external arrangers, with the final selection currently underway. If NPLs are found to have a real economic value below the net book value, their transfer should transparently result in a reduction of capital ratios. Any undercapitalization that could arise should be promptly addressed with credible capitalization plans. There should be a clear expectation and incentive structure for most NPLs to be transferred. NPLs remaining in banks’ book should be subject to progressive recognition of past losses (calendar provisioning), following European standards.

In a euroized economy without independent monetary policy, preserving healthy levels of financial sector liquid buffers is key to preserve stability and confidence. This is more so given the limited tools available to absorb shocks, heightened international uncertainty and increased volatility in financial markets. As expected, international reserves have fallen as banks deposits at CBSM moved abroad to take advantage of higher rates, a trend that is expected to continue in the near term..

San Marino should continue to make progress in strengthening 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 V AML directive into the domestic legal framework.

Reforms that preserve and support macroeconomic stability should be complemented with structural reforms needed to boost long-term growth. Progress towards the EU association agreement and the labor market reform are welcome but should be completed and implemented. In particular, labor market reform should make permanent the recent liberalization of cross-border workers and increase flexibility of temporary employment. Plans to improve the business climate are critical and further efforts are needed to improve an outdated insolvency framework.

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