DBRS Morningstar Assigns BBB (low) Credit Ratings to the Republic of San Marino

DBRS Ratings GmbH (DBRS Morningstar) assigned Long-Term Foreign and Local Currency Issuer Ratings of BBB (low) to the Republic of San Marino (San Marino). DBRS Morningstar also assigned Short-Term Foreign and Local Currency Issuer Ratings of R-2 (middle) to San Marino. The trend on all credit ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
San Marino’s credit ratings are underpinned by a relatively high GDP per-capita income, a sizeable net external position that benefits from a dynamic export performance, and a stable political system. On the other hand, the credit ratings are constrained by a high level of public debt; a large amount of nonperforming loans (NPLs), although this is expected to decline; low structural GDP growth; and weak administrative capacity, leading to poor data transparency and availability. Moreover, San Marino’s small and open economy exposes the country to external shocks.

The Stable trend reflects DBRS Morningstar’s view that risks to San Marino’s credit ratings are balanced. The Coronavirus Disease (COVID-19) pandemic and the impact of the energy shock have not led to material economic scarring. Strong nominal GDP growth and high windfall fiscal revenues have led to a material improvement in public sector accounts, and public debt is expected to continue to decline from a peak of 83.1% in 2021 to below 65% of GDP by 2026, according to the International Monetary Fund (IMF). While the successful issuance of a Eurobond in May 2023 reduced near-term refinancing risks public sector debt redemptions appear very high in 2027. Elections in 2024 might cause some fiscal loosening, but DBRS Morningstar views San Marino’s pension reform, expected disposal of NPLs, and possible association agreement with the European Union (EU) positively for the country. This agreement should further integrate San Marino into the EU, supporting trade, the labour market, and economic activity by reducing transaction costs and attracting foreign investment.

CREDIT RATING DRIVERS
DBRS Morningstar could upgrade San Marino’s credit ratings if one or a combination of the following factors occurs: (1) a significant decline in the public debt-to-GDP ratio because of a material and durable improvement in the public finance trajectory over the medium term; and (2) a continued effort to substantially reduce vulnerabilities in its financial sector.

DBRS Morningstar could downgrade San Marino’s credit ratings if one or a combination of the following factors occurs: (1) a worsening macroeconomic performance leading to a material deterioration in public finances; (2) a sizeable crystallisation of contingent liabilities, causing a significant rise in the public debt-to-GDP ratio; and (3) a significant deterioration in funding conditions.

CREDIT RATING RATIONALE

Strong Manufacturing Exports Mitigate Weak Structural Growth and High Vulnerability to Shocks

San Marino is one of the smallest economies in the world but enjoys a relatively high GDP per-capita income, which the International Monetary Fund (IMF) estimated to be USD 52,447 in 2022. San Marino, which had a population of around 34,000 and a GDP of around EUR 1.7 billion in 2022, is strictly dependent on Italy’s economic performance, including its demand for San Marino’s manufacturing goods. In recent years, the country’s economic model has shifted to a more stable manufacturing and tertiary economic model from an offshore banking system following the adverse impact of the global financial crisis and Italy’s decision to insert San Marino in a blacklist of jurisdictions with preferential tax regimes. Following the exit from Italy’s blacklist in 2014 the country concluded an agreement with the EU that aligned San Marino with the 2016 global standard on the automatic exchange of financial account information promoted by the Organisation for Economic Co-operation and Development in 2016. However, the country’s economic diversification remains limited as it is concentrated in the manufacturing sector, which currently accounts for one-third of GDP and 30% of employees. Moreover, one-third of employees in San Marino are foreign workers and the country’s small size makes it vulnerable to external shocks.

Despite the pandemic, the energy shock, and financial tightening, San Marino’s economy has demonstrated remarkable resilience benefitting from a good performance of the manufacturing sector. In 2020, the country’s GDP contracted by 6.8% (while Italy’s GDP declined by 9.0%) but rebounded strongly, growing by 14.2% in 2021 and by an estimated 5.0% in 2022. This growth also reflected strong export demand and limited impacts from the energy shock in light of negligible links with Russia and moderate increase in energy tariffs. This also led to inflation remaining more moderate in San Marino than in the euro area, even though inflation (FOI index) declined only slowly to 6.5% in August 2023 from its peak of 7.3% in December 2022. GDP growth is expected to be 2.2% this year before slowing to 1.3% in 2024, according to the IMF. Risks to the economic outlook are tilted to the downside but the potential agreement with the EU could mitigate the impact on the economy stemming from the slowdown of its main trading partners, particularly Italy.

The pandemic and the energy crisis did not constrain the steady improvement in the country’s labour market or the rapid recovery in its tourism sector. Also benefitting from an easy access of crossborder workers, the labour market improved. San Marino’s unemployment rate gradually improved to 4.3% as of October 2023—among the lowest levels over the last 12 years—since its peak at 10.1% in February 2016. Moreover, the easing of pandemic-related restrictions led to a fast recovery in tourist arrivals, which have exceeded 2019 levels. However, in DBRS Morningstar’s view, San Marino’s high concentration, weak GDP structural growth and dependence on Italy’s growth underpin a negative adjustment in the Economic Structure and Performance building block.

Public Accounts Improved Temporarily, but Fiscal Reform Would Bode Well For More Moderate Deficits Going Forward

San Marino’s public finance accounts have improved considerably after the impact of the pandemic. Fiscal revenue windfalls from high inflation along with conservative fiscal policy returned the budget to a surplus position last year, but this improvement is expected to be temporary. The implementation of fiscal reform could bolster fiscal prudence over the medium term. Still, the lack of a medium-term fiscal strategy, which would improve budgetary predictability, weighs on the Fiscal and Performance building block.

After years of moderate deficits, averaging 1.7% of GDP in the 2015–19 period, the budget deficit worsened to 37.6% of GDP in 2020 mainly as a result of measures to help the banking sector, according to the IMF. San Marino’s strong economic recovery, including declining support for banks, shifted its budget balance to a positive position of 0.4% of GDP in 2022 with an improved structural primary balance, net of bank support, of 1.1% of GDP to 0.6% of GDP in 2022, according to the IMF latest estimates. San Marino’s fiscal support to counteract the impact of high energy prices has been contained, enabling the price-signal mechanism to reduce demand, but the budget balance will likely return to a deficit of around 2.2% of GDP in 2023, mainly because of weaker economic activity. Upcoming elections in 2024 might generate some fiscal loosening, but the deficit should remain moderate. The IMF’s latest projections anticipate an average annual deficit of 1.4% of GDP in the 2024–26 period.

The government aims to reduce its deficit over the medium term by introducing fiscal reforms to broaden the tax base, reduce allowances, introduce a value-added tax and improve efficiency on public expenditure. Last year, parliament also passed an important reform to the pension system which, by increasing the contributions and marginally raising the retirement age, will delay the depletion of pension fund assets. However, additional effort might be necessary in the future to address challenges related to the ageing population.

Financial System Vulnerabilities Expected to Be Reduced by the Disposal of NPLs and Structural Reforms

San Marino’s banking sector continues to pursue an in-depth restructuring process, but the NPL ratio remained high at 51.5% (127.1% net of provisions to capital) as of Q2 2023. This, alongside mixed levels of capitalisation among banks and weak profitability, makes the system vulnerable. While total assets in the banking system are estimated to have declined to around 251% in 2022 (EUR 4.3 billion) from around 650% of GDP in 2009 (EUR 9.6 billion), the government has continued to provide significant support to the financial system over the years. Contingent liabilities related to the financial sector could also stem from the Central Bank of San Marino (CBSM)’s potentially weak capacity to act as a lender of last resort. This is because San Marino has adopted the euro as its national currency but is not a member of the euro system, and interest rate differentials on central bank deposits can generate outflows. A resurgence of deposit outflows might increase liquidity pressures, even though San Marino can use a EUR 100 million repo credit line from the European Central Bank to mitigate this risk, if necessary. These factors, including weak data availability and the fact that the bank resolution framework is not still aligned with European standards, contributed to DBRS Morningstar’s negative adjustment on the Monetary Policy and Financial Stability building block.

Liquidity in the banking system is improving and the disposal of NPLs and the introduction of the calendar provisioning should mitigate financial stability risks. Moreover, liquidity in the banking system has increased with the ratio of liquid assets to total assets rising to 26.5% in 2022 from 15.2% in 2018. Going forward, the disposal of NPLs and the implementation of structural reforms should support confidence in the sector. San Marino aims to reduce NPLs in the banking sector significantly through a securitisation programme. This programme would target around EUR 700 million out of around EUR 1.0 billion in impaired assets, which should benefit from the government guarantee on senior tranches. Moreover, the introduction of calendar provisioning would generate additional costs for banks, but it would also improve predictability and encourage banks to reduce NPLs.

High Public Debt and Sizeable Rollover Amounts Make Public Debt Vulnerable, Despite Low Sensitivity to Interest Rate Increases

San Marino’s public debt-to-GDP ratio increased by almost 24 percentage points to around 81.3% of GDP in the 2020- 2021 period before falling to an estimated 76.7% of GDP in 2022. The country’s high level of public sector debt, which the IMF projects to fall to around 72.2% of GDP in 2023, constrains the government’s fiscal space and leaves the economy vulnerable to shocks. The country’s high debt level mainly reflects the government‘s rescue packages provided to the financial system over the years. The IMF expects the public debt-to-GDP ratio to continue to fall below 65.0% of GDP in 2026 on the back of prudent fiscal policy and moderate economic growth. DBRS Morningstar does not expect further sizeable bank support in the near term but it does not rule out in the future the materialisation of contingent liabilities stemming from the financial system, which could negatively affect the debt trajectory.

The country’s public debt profile mitigates the risks associated with higher interest rates, but it is vulnerable to rollover risks. San Marino’s public sector debt has relatively long maturities and only 5.0% will be variable rate by the end of 2023, according to the IMF. Moreover, 56% of the country’s debt is nonmarketable with low funding cost and long maturities, which makes public debt largely resilient to volatile interest rates. However, DBRS Morningstar views some vulnerabilities when a large amount of debt has to roll over. Public debt redemptions are concentrated, particularly in 2027 when borrowing needs are estimated to be 23% of GDP. This is further exacerbated by the fact that the domestic debt market is relatively illiquid. These factors lead to a negative adjustment to the Debt and Liquidity building block.

A Sound External Position Mitigates Risks of Capital Outflows Due to High Interest Rates Abroad

San Marino’s credit ratings benefit from a sound external position, reflecting dynamic exports and a sizeable net foreign asset position. On the other hand, a high reliance on Italy’s import demand, accounting for around 80% of San Marino’s total exported goods, makes the country highly dependent on Italy’s economic performance. Higher interest rate differentials might generate further capital outflows.

The manufacturing export-oriented sector has shown resilience, despite the impacts of the pandemic and the energy crisis, while tourist arrivals have recovered and are now exceeding 2019 levels. According to the IMF, San Marino posted a sizeable current-account surplus of 8.0% of GDP in 2022 following a surplus of 6.5% in 2021. This was largely attributable to an improvement in its cost-competitive position in pre-pandemic years and to supply disruptions affecting export competitors. Weaker trade growth and the economic slowdown in Italy will likely translate into more moderate current-account surpluses over the medium term; the IMF medium-term projections suggest a surplus of 3% of GDP in 2023-2026 period.

The country’s net foreign asset position was sizeable at around 123% of GDP in 2022, benefitting from a large amount of commercial bank assets abroad underpinned by a positive export performance. However, higher interest rates in Europe led local banks to transfer part of their deposits abroad from the central bank, which reduced the amount of foreign-exchange reserves. According to the IMF, gross international reserves declined to from their peak of EUR 842 million in 2021 to EUR 533 million at the end of 2022.

San Marino’s Political Stability Bodes Well for Policy Making; Next Agreement With the EU Expected to Extend EU Market Access

San Marino’s credit ratings benefit from a stable political environment, which should preserve policy continuity and reduce regulatory uncertainty. The country also has robust World Bank governance indicators. However, structural reform implementation tends to be slow which, in DBRS Morningstar’s view, weighs on the government‘s capacity to address economic challenges. As a result, DBRS Morningstar applied a negative adjustment to the Political Environment building block. The RETE Movement’s decision to withdraw from the government coalition should not undermine stability as the government can still be supported by a solid majority. Nevertheless, passing new important reforms, including the fiscal and the banking sector reform are unlikely before the parliamentary elections next year.

The economy is not part of the Schengen Area, but San Marino has enjoyed a Cooperation and Customs Union Agreement with the EU since 1991, which eliminates all tariffs and non-tariffs for almost all goods. Together with Andorra, the government of San Marino is negotiating a unique association agreement with the EU that will seek to reduce legislative barriers and ease bureaucracy, thereby expanding market access. Although concerns over weak oversight in the banking sector and regulation in the labour market could delay the conclusion of the agreement, DBRS Morningstar expects it to be ratified before the EU parliamentary elections are held in spring 2024. The successful conclusion could provide some upside to San Marino’s economic growth, enabling the free movement of people, workers, and services.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

There were no Environmental and Social factors that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
DBRS Morningstar considered the Institutional Strength, Governance, and Transparency factor to be relevant for San Marino’s credit ratings. Compared with other peers, San Marino shows a weaker data availability transparency and lacks a medium-term fiscal and debt strategy that would make public finance indicators more predictable. Moreover, the banking resolution framework is not aligned with EU standards and the reform effort appears slow. DBRS Morningstar has taken these factors into consideration in the Fiscal Management and Policy, Debt and Liquidity, Monetary Policy and Financial Stability and Political Environment building blocks.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (4 July 2023) at https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/424789.

Notes:
All figures are in euros unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments (6 October 2023), https://www.dbrsmorningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings, in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for these credit ratings include IMF (WEO October 2023, IFS, Article IV - November 2023, World Bank, Central Bank of San Marino, Prospectus Bond Emission EUR 350 million - May 2023, Haver Analytics, Bank for international settlements, European Commission, Ufficio Informatica, Tecnologia, Dati e Statistica, San Marino’s implementation of the 2030 Agenda for sustainable development. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

These credit ratings concern a newly rated issuer. These are the first DBRS Morningstar credit ratings on this issuer.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

DBRS Morningstar does not audit the information it receives in connection with the credit rating process, and it does not and cannot independently verify that information in every instance.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and credit ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/424788.

This credit rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Carlo Capuano, Senior Vice President, Credit Ratings, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Credit Ratings, Global Sovereign Ratings
Initial Rating Date: 1 December 2023
Last Rating Date: Not applicable as there is no last rating date.

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