San Marino: Staff Concluding Statement of the 2018 Article IV Mission

January 17, 2018

Maintaining financial stability and restoring banking sector soundness remain key priorities. Public support of the banking sector needs to come with improvements in accountability and oversight. Fiscal adjustments are envisaged but public debt prospects will depend on the final fiscal costs of banking system repair. Continued structural reforms, including reducing red tape, will help reorganize the economy. The reform agenda is demanding and requires strong commitment of all stakeholders.

Outlook and Risks

1. The economy rebounded in 2016 but momentum is slowing amid banking sector uncertainties with a sizable loss reported by the largest bank and a closure of a small bank in 2017. The economy grew at around 2 percent in 2016, supported by a buoyant external environment, but high frequency indicators, including decelerating employment growth, suggest that economic growth slowed somewhat in 2017, to around 1.5 percent. Despite improved economic activity, banking sector deleveraging continues, and credit to the domestic economy declined further in 2017.

2. Moderate growth is expected in the near- and medium-term. Under the baseline scenario, the economy is expected to grow at slightly above 1 percent in 2018 and beyond, driven by private consumption benefitting from past employment gains. However, investment remains weak, lacking support from the deleveraging banking sector.

3. This baseline scenario is subject to downside risks. An incomplete domestic banking sector reform, including delays or a failure to properly restructure the largest bank, could lead to a further loss of confidence in the system and hinder provision of credit to the economy. An increase in fiscal costs from the banking sector repair, through realization of contingent liabilities such as conversion of tax credits into government bonds, could put further pressure on public finances.

Financial Sector Policy

4. A coherent strategy is needed to restore confidence and soundness of the banking system. Lingering banking sector problems, built up over the last decade, have incurred high costs for the state. The authorities’ recent efforts to identify the problems are welcome, and they understand the need to decisively address them. A new strategy for the banking sector with permanent solutions is urgently needed to minimize costs to taxpayers, safeguard financial stability, and ensure that the banking system is viable and contributes to the economy. This should include upfront loss recognition, prompt bank recapitalization, and non-performing loans (NPLs) resolution, supported by measures to improve transparency and accountability, and enhance the financial sector infrastructure. Decisively addressing banking sector problems requires the following immediate actions:

• Bank balance sheet repair. The turnover of central bank management led to a significant delay in the post-Asset Quality Review (AQR) process, and an AQR update is now necessary to identify and address capital shortfalls. Recapitalization should follow within a short timeframe. Market-based solutions should be sought, and public capital support should be limited to only viable, systematically important banks, following burden sharing. Bank governance also needs to be strengthened, including risk management, and making new and existing management subject to rigorous fit and proper tests.
• Deep restructuring of Cassa di Risparmio della Repubblica di San Marino (CRSM). Upfront loss recognition and fresh capital are needed. CRSM needs to be restructured to return to viability, including by changing its business model, reducing high operating costs, and ensuring prudent lending. The state aid provided during 2012-2016 amounts to €220 million (about 16 percent of GDP) and will increase further due to a very large additional loss being now reported. This loss needs to be recognized immediately, and current shareholders and subordinated debt holders should absorb the loss before new capital is injected. Involvement of all stakeholders, including social partners and the state, is essential to reduce CRSM’s operating costs to limit further burden on tax payers. A quick re-privatization of the bank should be a priority, and the government should explore outsourcing some management functions, including to large foreign banks, to promote development of a sound business model while immediately improving risk and liquidity management.
• Managing NPLs. Banks should be subject to ambitious and credible plans aimed at significantly reducing NPLs over the medium-term, including through outsourcing loan collection and workout. These efforts should be supported by regulatory, tax, and legal reforms, including removing remaining tax disincentives to NPL disposals and enhancing effectiveness of the insolvency and enforcement regimes. The recent launch of a domestic credit registry is a welcome step to help restore payment culture, and harmonization to facilitate information exchange with Italy should be completed. The partial opening of the real estate market to nonresidents will help support collateral values during asset recovery. A formal asset classification and provisioning framework should be considered to ensure that banks have adequate capital in the future to tackle NPLs.

5. Improvements in accountability, governance, oversight and communication should be a prerequisite to further use of state resources to support the banking system. A financial stability committee is needed to improve coordination between the government and the central bank, especially for communication. A memorandum of understanding would help clarify responsibilities and a protocol for information exchange. The recently established financial stability task force, consisting of the government, central bank and banks, is nevertheless helpful to facilitate dialog and understanding among stakeholders.

6. Strengthening central bank functions and bank oversight is crucial to secure financial stability going forward:

• Crisis management capability urgently needs to be improved at the Central Bank of San Marino (CBSM) by establishing a lender of last resort and bank resolution unit equipped with appropriate policies and infrastructure to deal with vulnerable banks.
• Improving regulation and supervision is needed to strengthen banking system oversight. Developing a capacity to monitor systemic risks is also needed to ensure financial stability.
• Central bank reform will help ensure effective bank supervision and should proceed by reviewing the CBSM powers and mandate and implementing key suggestions from the 2016 CBSM internal audit, including separating non-core activities. Adopting the highest standards of central bank independence, governance, accountability, and transparency as identified by the Bank of International Settlements is also key.

Fiscal Policy

7. Public finances have been managed prudently to limit the deficit in recent years, but public debt is bound to rise further due to bank recapitalization costs. While specific modalities are yet to be defined, the state’s assumption of the CRSM’s legacy loss implies a substantial rise in public debt, posing new debt management challenges.

8. Anticipating rising public debt, the 2018 budget envisaged fiscal adjustments, including extraordinary tax measures and some current spending cuts. These adjustments imply a close to balanced budget for 2018, and declining debt-to-GDP ratio in the medium-term. However, the budget and level of public debt are highly uncertain, depending on the final costs of bank recapitalization.

9. A fiscal strategy should aim to ensure debt sustainability and support growth. It should entail greater revenue collection, reviewing the level and quality of spending, enhancing debt management, and diversifying financing options. The 2018 budget already appropriately contains some of these elements:

• Increasing tax revenues. The planned tax measures, including the re-introduction of a wealth tax, will help increase revenues, but indirect taxation reform should play a pivotal role in raising revenues in the medium term.
• Containing spending and improving its quality. A modest reduction in the wage bill could be explored as its share in current spending remains higher than euro area countries. The spending review will help identify further areas for savings. Increased capital spending annually for 2018-19 will help support growth. Ensuring social security is self-financed would free resources for other priority areas. However, the current pension reform proposal is complex with multiple objectives and would benefit from prioritization to increase its effectiveness.
• Developing debt management capacity. Debt management capacity needs to be enhanced to effectively record, monitor and manage higher public debt to assure public debt transparency and sustainability.
• Diversifying financing options. Establishing access to external financing for the sovereign would enhance the government’s ability to respond to shocks.

10. A realization of contingent liabilities may require a more ambitious fiscal adjustment. Additional financial sector costs than expected would put further pressure on the public finances. Efforts should be made to use appropriate burden sharing and reduce contingent liabilities arising from the potential conversion of banks’ tax credit into government bonds.

Structural Reforms

11. Several structural reform measures have been implemented in 2017. The recent change in the hiring process of non-residents is a step towards easing skills shortages and improving productivity through better matches in the labor market. Increased labor market flexibility should be supported by a well-targeted social policy, where benefits are means-tested and linked to training and job search requirements to help unemployed workers engage in the labor market. Further measures to improve the business environment are underway, including establishing a one-stop-shop aimed at reducing costs of doing business.

12. San Marino’s continued efforts to engage with the international community and enhance transparency are crucial. The recently ratified regulatory update of the AML/CFT framework will help improve the credibility of the system. A framework for due diligence should be developed for the new residency programs to safeguard financial integrity. Further cooperation with Italy, including establishing a memorandum of understanding with the Bank of Italy, will be important to strengthen institutional capacity of San Marino.

13. Data provision needs to be strengthened. Easy access to timely economic data enhances transparency and is essential for investors, businesses and policy makers to make informed decisions. Priorities include compilation of balance of payments statistics and ensuring compliance with international standards in existing statistics. A clear timeline will help manage the process. More resources should be allocated to improve data provision and presentation, and expedite the compilation of basic data in priority areas.

The mission would like to thank the authorities, representatives from the private sector, and social partners for open and productive discussions and their warm hospitality.