Mission Concluding Statement 

San Marino: Staff Concluding Statement of the 2024 Article IV Mission

October 4, 2024

Washington, DC – October 4, 2024:

San Marino’s economy remains resilient, supported by a more diversified growth model with manufacturing and the nonfinancial service exporting sectors as key drivers. Prudent fiscal policy and access to international capital markets helped weather the pandemic and energy crises. However, additional fiscal consolidation is warranted given the still high debt level and contingent liabilities from the financial sector. Notwithstanding important progress in resolving legacy issues, further efforts are needed to improve asset quality and strengthen banks’ capitalization and profitability. With the recently negotiated European Union (EU) association agreement, San Marino has a unique opportunity to accelerate much-needed public and financial sector reforms and to further the integration with the EU’s single market to boost confidence in the economy and lift potential growth.

San Marino’s economic growth remained positive despite adverse external shocks, including a regional slowdown and higher interest rates. After an exceptionally strong post-pandemic recovery in 2021-22, growth slowed in 2023 to 0.4 percent following a decline in external demand. Manufacturing, which has been operating at high levels, has decelerated as export orders declined, in part due to the phase-out of fiscal incentives in Italy and a related slowdown in the construction sector. The strong service sector performance, benefiting from the tourism boom and healthy domestic demand, kept employment growing at a robust pace.

Growth is projected to edge up in 2024, strengthening further in 2025, as external demand improves. Stronger consumption on the back of rising real wages and higher investment, facilitated by easing financial conditions, will support domestic and external demand next year. However, there are risks ahead. Downside risks are related to the weakening of external demand while remaining vulnerabilities in the financial sector constitute one of the key domestic risks. The underlying strength of the manufacturing sector, the healthy private sector balance sheets, and prompt implementation of the EU association agreement constitute upside risks to the baseline.

The fiscal position was stronger than expectedlast year but further efforts are needed to ensure sustainability.The government has saved the cyclical tax revenues, kept expenditures in check and primary balance stable in 2023. However, moderate government spending pressures arose in 2024 ―as real spending compression reached its limits and the cost of interest subsidies for the private sector expanded. The public debt-to-GDP ratio continued declining, but its level remains high.

Additionalfiscal consolidation is needed to mitigate financing risks, build fiscal buffers, and reduce the debt-to-GDP ratio below 60 percent.San Marino is an euroized small open economy with a vulnerable financial sector and limited fiscal buffers. The government’s goal of reducing public debt below 60 percent of GDP over the medium term is an important anchor to guide fiscal policy. To achieve this target a moderate additional fiscal effort totaling 1 percent of GDP over the next three years is recommended through:

• Designing and implementing a tax reform package introducing a value-added tax (VAT) and broadening the income tax base. With a low tax-to-GDP ratio, introducing a VAT in San Marino can simultaneously enhance fiscal revenues and tax efficiency while minimizing related distortions, increasing fairness and progressivity, and aligning indirect tax procedures with international standards, benefitting the ease of exports. Redesigning tax rebates to avoid overlaps with other exemptions—such as San Marino Card (SMaC) discounts and income tax deductions—can further rationalize the system. The authorities should leverage the technology used for the SMaC in combination with electronic invoicing to mitigate tax avoidance in the new VAT system. Equallyimportant, income tax revenues can be significantly enhanced by rationalizing income tax deductions.
• Improving the efficiency of public spending.San Marino should shift from real expenditure compression across all spending areas to prioritizing consolidation of spending with low social return. In this context, it will be important to review transfers to the private sector―including interest subsidy programs―to ensure that transfers are more targeted. Reviewing extra-budgetary funds is also needed to rationalize spending. Large investment plans require sound prioritization based on rigorous cost-benefit analyses.
• Keeping public wages and pensions growth in check. Moderate public wage and pension growth was key to improving the primary balance. Looking forward, given the limited fiscal space, it is critical to avoid public wage and pension growth above domestic inflation.

Long-term demographic challenges will require additional parametric pension recalibration. The 2022 pension reform has increased contributions, delaying the depletion of the pension fund for a decade. However, ensuring the long-term sustainability of the pension system will require further parametric calibrations to address generous benefits. In addition, there is a need to continue the gradual diversification of the investments of the pension fund towards international markets to mitigate concentration of risks and increase returns.

The debt management strategy needs strengthening to minimize refinancing risks. The recently published fiscal strategy marks an important advancement in the predictability of fiscal policy and communication with investors, but further efforts are needed to upgrade San Marino’s debt management capacity, including more autonomy to implement the financing plan approved in the budget. To smooth the debt amortization of the Eurobond in 2027, the authorities should consider liability management operations, including smaller international issuances with longer maturities.

Banks’ liquidity and reported profits improved in 2023, but declining interest margins, high personnel costs, and remaining legacy non-performing loans (NPLs) pose risks going forward. Higher interest rates last year have improved banks’ cyclical profits without deteriorating the quality of loan portfolios, but structural profitability remains low. The safeguarding of profits to increase capital, as requested by the Central Bank, is welcome. However, with limited income-generating assets, high operating costs, and tight reported capitalization in some banks, the financial sector remains vulnerable.

A speedy adjustment of banks’ costs is a priority to improve long-term viability and capital positions. Most banks’ profitability remains significantly lower than regional peers. The continuing reduction of income-generating assets in recent years has not been followed by a scale-down of banking sector employment. San Marino’s banking system also has the largest number of branches per capita in Europe. With the EU association agreement, the opening of the banking sector will bring new opportunities, but San Marino banks need to improve efficiency to be competitive.

Important progress has been made in implementing the authorities’ strategy to reduce nonperforming loans (NPLs) through an Asset Management Company (AMC) and calendar provisioning. The write-off of a large NPL position and AMC securitization have reduced the NPL ratio from 53 to 21 percent. The asset recovery of the AMC has progressed better than expected, with the principal of state-guaranteed senior securities declining from 70 to 44½ million euros in the first half of 2024. Meanwhile, calendar provisioning has prompted banks to expedite the recovery and write-offs of NPLs. However, it will be important to improve dissemination of the information about the AMC asset recovery to anticipate and address any bottlenecks. The risk weights for junior securities should be increased faster to reflect the difference between the net book value and the real economic value of NPLs on banks’ balance sheets. Any undercapitalization that could arise from the securitization process and the implementation of calendar provisioning should be promptly addressed with credible capitalization plans. To strengthen CBSM supervisory powers and to help attract external capital, legal limits on banks’ shareholding structure should be lifted.

The bank resolution framework needs to be updated to widen burden-sharing. The bank resolution law should be updated to gradually complete the alignment with EU standards. The process needs to be coordinated with addressing existing issues in the banking system.

San Marino should continue to make progress to strengthen its AML/CFT framework. The domestic legal framework was amended in 2023 to incorporate the 5th EU AML Directive and improve technical compliance with the FATF standards. This resulted in an upgrade by MONEYVAL on technical compliance for AML/CFT sanctions regime. The National ML/TF Risk Assessment will be updated next year. San Marino should continue working to enhance the adequacy, accuracy, and up-to-dateness of its central beneficial ownership registry.

The EU association agreement sets an ambitious financial sector reform agenda. The agreement requires the central bank of San Marino (CBSM) to complete the alignment of the regulatory framework with the EU. To that end, the CBSM will need additional staff and financial resources. The CBSM financial position should be strengthened to safeguard its independence and support financial sector stability through an effective lender of last resort capacity. To comply with EU standards, legacy issues should be addressed, including through a gradual conversion of the perpetual bond owned by the state-owned bank into liquid instruments. Overall, while the banking sector has 15 years to meet the requirements, earlier implementation, as envisaged by the authorities, will boost confidence.

The conclusion of the EU association negotiations signals strong commitment to deeper integration with the EU and could lift potential growth by accelerating structural reforms. The successful implementation of the agreement is a priority and will support the competitiveness of the manufacturing sector and help consolidate gains in tourism. The authorities should ensure sufficient resources and staff are available to support implementation without undermining the fiscal consolidation path. In addition, further labor market flexibility is needed to improve labor reallocation, including in the banking sector. Real estate market reforms to facilitate price and market information dissemination and foreign ownership, will be key to support NPL resolution. Finaly, the authorities should foster energy safety and green transition, including by allowing households to sell back excess solar generated electricity.

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