February 1, 2019

San Marino’s key challenge is to urgently return its economy to a sustainable path of growth and prosperity. This requires prompt implementation of a comprehensive package of policy actions aimed at stabilizing the banking system and restoring credit supply while safeguarding public finances. Priority should be given to recognizing losses and recapitalizing banks upfront, quickly reducing the operating costs and non-performing loans (NPLs), and overhauling banking sector oversight and governance. Sustained growth-friendly fiscal consolidation and continued structural reforms are also needed to ensure public debt sustainability, improve competitiveness, and boost potential growth.

Significant risks call for prompt policy actions

1. San Marino’s growth prospects are weighed down by legacy problems and downside risks. Deep-rooted weaknesses in the banking system coupled with ineffective and piecemeal responses to past bank failures have stalled credit growth and are now threatening financial stability and fiscal sustainability. Banks’ ability to serve one of their critical functions in society as the intermediators between savers and borrowers is extremely limited. The economy remains highly vulnerable to shocks, and—absent a swift and significant policy adjustment—economic growth is projected to remain subdued over the near and medium term due to continued banking system deleveraging and less favorable external conditions. Elevated financial and fiscal fragilities suggest that the outlook is dominated by significant downside risks.

2. Shifting the economy to a sustainable growth path is urgently needed. Restoring credit supply, stabilizing the banking system, and mitigating fiscal risks require immediate implementation of a coherent strategy that consists of banking system restructuring and recapitalization, an ambitious and growth-friendly fiscal consolidation, and structural reforms to boost competitiveness and bolster growth. A full commitment of all stakeholders in San Marino is critically important for a successful implementation of this strategy.

Restore the banking system’s role in the economy

3. The banking system is vulnerable on multiple fronts. This over-sized sector suffers from deep capital, asset quality, governance, and profitability problems. As a result, liquidity has fallen to low levels, leaving the banking system and the economy vulnerable to shocks. Past bank losses have yet to be properly recognized and large recapitalization needs have remained largely unaddressed, undermining banks’ ability to extend credit to the real economy. With negative credit growth, high levels of NPLs and tax credits, and excessively high operating costs, the banking system is estimated to have recorded a loss in 2018, the ninth year in a row.

4. A multi-pronged approach is urgently needed to restore banking sector viability. The Central Bank of San Marino (CBSM) is making progress on several fronts that will promote financial stability, but lack of sufficient powers, autonomy, and consultation on financial sector related policies hinder its effectiveness. Improved coordination among policy stakeholders is needed to urgently design and implement a comprehensive financial sector strategy that should consist of measures to:

• Improve liquidity management. CBSM liquidity buffers have declined to low levels in recent years due to continued lending to the government and the banking sector. The CBSM should enhance liquidity management and restrict budget financing to only exceptional needs and on a temporary basis. Well-developed measures and carefully-crafted communication are urgently needed to respond to a potential resurgence in liquidity pressures and to safeguard the payment system.

• Recognize losses and recapitalize banks upfront. The capital shortfalls, which are largely concentrated in the state-owned Cassa di Risparmio della Repubblica di San Marino (CRSM), should be addressed upfront and the laws that allow banks to spread losses should be repealed. State support should be provided only to systemically-important and viable banks, following burden sharing, while other undercapitalized banks that fail to raise fresh capital from private sources should be subject to corrective action.

• Improve efficiency and sustainability. High operating costs need to be quickly reduced, including by reviewing employees’ compensation and rationalizing the branch network. Converting tax credits into interest-bearing assets is critical to restore banks’ long-term sustainability.

• Speed up NPL resolution. Supervisory oversight should urgently be strengthened to reduce the extremely high levels of NPLs, including by requiring banks to achieve ambitious, but realistic, NPL reduction targets. This should be complemented with modernizing the insolvency regime, removing tax disincentives for NPL disposal, and streamlining legal proceedings for liquidation and enforcement. The recent decision to fully liberalize the real estate market will help by improving collateral recovery values.

• Strengthen financial sector oversight and governance. CBSM bank intervention tools urgently need to be brought to international standards to safeguard financial stability. This should be supported by steps to review the Central Bank law with a view to enhance its independence, governance, and accountability. Improved CBSM communication with local stakeholders will enhance transparency and credibility.

Safeguard public finances and reduce fiscal risks

5. The cost of banking system repair continues to weigh heavily on public finances. The 2019 budget aims at achieving a small surplus, net of government support to CRSM. However, with inclusion of the expected transfers to CRSM, the mission projects the overall deficit at 2.4 percent of GDP in 2019, and about 3 percent of GDP over the medium term due to government’s gradual recapitalization of CRSM as well as expiration of temporary fiscal measures. Absent further adjustment, the related financing needs will keep fiscal buffers low, undermining the economy’s resilience.

6. Fiscal risks are exacerbated by the State’s commitments to the banking system. The official public debt—although increasing—is projected to remain low at 27.5 percent of GDP in 2018. However, a full and upfront cost recognition arising from past bank interventions—namely CRSM legacy losses and tax credits given to banks for acquiring failed ones—would increase public debt substantially, posing significant stability risks, especially given the current lack of market access, limited domestic financing options, and weak debt management capacity.

7. A comprehensive fiscal strategy is critical to ensure public debt sustainability while gradually rebuilding fiscal buffers. Alongside burden sharing in bank recapitalization, an ambitious fiscal adjustment that relies on durable revenue and expenditure measures should be pursued. Specifically:

• Revenue. The planned VAT should be adopted with sufficiently-high rates and limited exemptions to boost revenue collection, and in a timeline that is consistent with the tax administration capacity. Rationalizing wasteful tax rebates and maintaining the wealth tax would also help increasing revenue.

• Expenditure. A comprehensive pension reform that will effectively address San Marino’s ageing pressures and ensure the sustainability of the pension system would support fiscal consolidation efforts. Well-targeted social policy—where benefits are means-tested and linked to job search—and a higher spending efficiency across government units are also necessary to contain expenditure. The introduction of an income and wealth indicator to support means-testing as well as strengthening the controls over budgeting of government units and state-owned enterprises are welcome.

8. Improving debt management capacity and diversifying sovereign financing sources would help reduce fiscal risks. Setting up a Treasury unit, strengthening macro-fiscal planning, and establishing access to external financing would enhance the government’s ability to respond to shocks and contain debt financing risks.

Sustain structural reforms to boost economic growth

9. Safeguarding the reform momentum would foster future development and improve medium-term growth prospects. Recent reforms have started to bear fruit, but more needs to be done to address remaining structural impediments. Special attention should be given to:

• Further improving the business environment. San Marino has made progress in improving the business climate in recent years, including by removing several impediments for starting a business. Additional reforms aimed at streamlining judicial processes, enhancing creditors and borrowers’ rights, and improving corporate governance would further improve external competitiveness.

• Strengthening labor supply. Continued steps to increase flexibility in hiring nonresidents would help reduce skill mismatches and alleviate capacity constraints. The recently established Office for Active Labor Market Policies could support higher employment and growth by more targeted social benefits as well as enhanced training and job search.

• Increasing economic integration and addressing infrastructure gaps. The new Economic Development Agency is expected to help expand market access for domestic firms, attract tourists, and promote higher foreign direct investments, while a conclusion of the Association Agreement with the EU would bring further benefits, including by simplifying the operations of Sammarinese firms abroad and potentially granting them passporting rights. These efforts should be complemented by higher investment in telecommunication and transportation to improve business connectivity with trading partners.

Further improve data provision for surveillance

10. Progress has been made in enhancing data provision. Welcome progress was made in reporting monetary and financial data regularly and in compiling balance of payment and international investment position statistics for the first time. Ensuring that sufficient resources are allocated to the Statistical Office and the CBSM would help close the remaining data gaps and improve the frequency, coverage, and reporting of relevant statistics. This would allow businesses and policymakers to better assess the state of the economy and make informed decisions.

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The mission would like to thank the authorities, private sector participants, and other interlocutors for the open and productive discussions and their warm hospitality.