F.P. Report
Washington, DC: On November 21, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with the Republic of San Marino and considered and endorsed the staff appraisal without a meeting.
San Marino’s economy has been remarkably resilient over the last two years. After Russia’s invasion of Ukraine, San Marino faced an unprecedented energy price shock which, compounded with a food price shock, led to high inflation and real income erosion. However, the strong external demand amidst global supply chain constraints and an elevated inflow of tourists have boosted economic activity. GDP is estimated to have grown by 8.3 percent in 2021 and 3.5 percent in 2022. The strength of the manufacturing sector has been a key source of resilience.
The energy shock has been milder than in neighboring countries as San Marino secured beneficial energy import prices this year and next, that have resulted in tariffs below regional peers at minimal fiscal costs. At the same time, the authorities have allowed price signals to guide demand, while minimizing the disruptive economic impact and supporting vulnerable groups. Despite a strong recovery and the withdrawal of covid-related support, the fiscal position remains weaker than before the pandemic largely due to ageing-related spending pressures. Meanwhile, banks’ capitalization and profitability improved in 2021, while deposits grew. However significant challenges remain given very large nonperforming assets and weak capitalization.
Macroeconomic risks to the economy are significant, including high energy prices and further disruptions to energy supply, tightening financial conditions, and growing global uncertainty. Therefore, it is key to build fiscal and financial buffers, while accelerating the reform agenda. With elevated public debt and the large Eurobond rollover in 2024, an ambitious fiscal consolidation is needed to ensure sustainability and reduce risks. In this connection, the approval of pension reform expected this year and income tax reform next year are key and cannot be delayed. With likely higher-for-longer interest rates and energy prices, the banking system enters a stage of new challenges. Thus, there is a need to strengthen capital, improve banks’ efficiency and accelerate the reduction of nonperforming loans avoiding fiscal risks and forbearance. Finally, reforms that preserve and support macroeconomic stability should be complemented with structural reforms needed to boost long-term growth.
Executive Board Assessment [2]
With higher energy prices, tightening financial conditions, and growing global uncertainty, activity is expected to slow down. Therefore, the priority should be to build fiscal and financial buffers, while accelerating the reform agenda. The rollover of the Eurobond maturing in 2024 remains a risk.
The authorities’ response to high energy inflation allows price signals to operate and supports vulnerable groups. A combination of a long-term gas contract and timely electricity hedging operations, just before prices surged has allowed to adjust tariffs to cost recovery levels but well below neighboring countries. This was done at minimum fiscal costs and avoiding the potentially disruptive macroeconomic impact associated with large tariff increases. 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.
Increasing global interest rates, elevated public debt, and the pending Eurobond roll-over, call for an ambitious fiscal adjustment notwithstanding weakening economic activity. With increased global financial uncertainty, the authorities should opportunistically rollover the Eurobond starting early next year whenever market conditions are favorable. Given the deteriorating 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 reducing exemptions and loopholes. Introduce the VAT.
· 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.
· Pensions: The proposed pension reform 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 cannot be delayed given increasing deficits of the Social Security.
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 that increases predictability. In this context, the conversion of ex-BNS uninsured depositors’ bonds will help develop the domestic debt market and reduce the burden on taxpayers.
Banks’ profitability and capitalization have improved, but significant challenges remain. With extraordinarily high NPLs and the recent halt of efficiency improvements, profitability remains limited and fragile. In the context of falling bond valuations, new pressures on the capital base have arisen. The plan to transparently report the transfer of assets from the trading to the investment portfolio that is held until maturity is welcome.
The implementation of the strategy to reduce NPLs should not be delayed further. The delays have postponed banks own NPL resolution. 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 incentive structure for most NPLs to be transferred and NPLs remaining in banks’ books should be subject to 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 the implementation of the AML/CFT framework. Efforts to transpose the EU AML directive into the domestic legal framework are welcome but should be expedited.
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.
