Morningstar DBRS Confirms the Republic of San Marino at BBB (low), Stable Trend

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

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects Morningstar DBRS' view that risks to San Marino's credit ratings are balanced. The country has demonstrated strong resilience despite multiple shocks including, the COVID-19 pandemic, the impact of the energy shock and high inflation. Strong nominal GDP growth and high windfall fiscal revenues have led to a material improvement in public sector accounts. A prudent government fiscal stance will facilitate a continued decline in government debt as a share of GDP from 73.4% in 2023 to around 66.4% in 2026, according to the International Monetary Fund (IMF). Government liquidity is now at a more comfortable level, and while the successful issuance of a Eurobond in May 2023 reduced near-term refinancing risks, public sector debt redemptions appear very high in 2027. Banking sector credit quality has improved as a result of the sharp reduction in nonperforming loans (NPLs), but further declines are expected, bringing the NPL ratio towards the European Union (EU) average going forward. Morningstar DBRS does not anticipate that upcoming elections will derail a prudent fiscal stance with the deficit projected to decline from 2.3% of GDP in 2023 to 1.4% in 2026. Moreover, the association agreement with the EU, expected to be effective next year, could further support San Marino's economic prospects by reducing transaction costs, opening new business opportunities in the EU and attracting foreign investment.

The country's credit ratings are underpinned by a relatively high GDP per-capita income, a sizable net external asset position that benefits from a dynamic export performance and a large amount of commercial bank assets abroad, and a stable political system. On the other hand, the credit ratings are constrained by a high level of public debt; a large, although declining amount of NPLs; 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.

CREDIT RATING DRIVERS
Morningstar DBRS 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 as a result of a material and durable improvement in the public finance trajectory over the medium term; (2) a material improvement in the debt profile and (3) a continued effort to substantially reduce vulnerabilities in its financial sector.

Morningstar DBRS 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 sizable crystallization of contingent liabilities, likely stemming from the banking system, causing a significant rise in the public debt-to-GDP ratio; and (3) a material deterioration in sovereign funding conditions.

CREDIT RATING RATIONALE

Weak Structural Growth and High Vulnerability to Shocks Are Mitigated by a Resilient Manufacturing Sector and Improved Labour Market

San Marino is one of the smallest economies in the world but enjoys a relatively high GDP per-capita income, which the IMF estimated to be USD 57,259 in 2023. The country, which had a population of around 34,000 and a GDP of around EUR 1.8 billion in 2023, 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 one from an offshore banking system. However, economic diversification remains limited as it is largely 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 high inflation, San Marino's economy has demonstrated remarkable resilience benefitting from a good performance of the industry and tourism sectors. After the strong rebound in real GDP growth of 14.2% in 2021, economic performance continued to show solid performance in 2022 with GDP expanding by 5.0%, reflecting a swift recovery in tourism, sound growth of goods exports, and limited links with Russia. Slower industry activity in 2023 weighed on GDP which is anticipated to have expanded by 2.3%. Over the medium term, GDP growth is expected to be above 1.0% on average. With a moderate increase in energy tariffs, inflation remained moderate in San Marino. Inflation (FOI Index), from its peak of 7.3% in March 2023, declined to 1.5% as of March 2024.

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 easy access of cross border workers, the labour market improved. San Marino's unemployment rate gradually improved to 4.3% as of March 2024¿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 now exceeded 2019 levels. However, in Morningstar DBRS' view, weak structural GDP growth, and concentration risk related to Italy's growth sources underpin a negative adjustment in the "Economic Structure and Performance" building block assessment.

Public Accounts Improved Temporarily, but Potential 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 a conservative indexation of public sector wages and pensions below inflation, have been easing pressure on the budget balance, which returned to a surplus position in 2022. But this improvement was temporary as weaker economic activity and high interest costs led the budget balance to shift again to a deficit estimated at 2.3% of GDP last year by the IMF. Morningstar DBRS does not anticipate a change in the conservative fiscal stance in coming years, although further financial system support from the government might happen. The deficit is likely to gradually narrow to 1.4% of GDP by 2026.

Morningstar DBRS views positively the past pension reform, which by increasing the contributions and marginally raising the retirement age, will delay the depletion of pension fund assets. Although a potential further increase in employment could provide additional social contributions to the pension funds, further measures to strengthen the pension system might be required over the medium term. Morningstar DBRS does not rule out fiscal reform under the next government. This could further reinforce public accounts by reducing tax expenditures and overhauling indirect taxes. However, budgetary predictability remains limited as the government lacks a medium-term fiscal strategy, and this weighs on the "Fiscal Management and Performance" building block assessment.

Banking Sector Vulnerabilities Are Declining Reflecting Disposal of NPLs; Calendar Provisioning Bodes Well for Better NPL Management

Weaknesses in the banking sector are gradually declining thanks to a reduction in NPLs and an improvement in capitalization and liquidity. Moreover, on the back of high interest margins, banks have increased their profitability, while the introduction of the calendar provisioning reinforces their ability to deal with NPLs. After setting up an Asset Management Company, a securitation programme, along with the write off of a large amount of impaired assets, the gross NPL ratio halved to 23.2% in December 2023 compared with 56.2% in the same period in 2022. The senior note of the NPL securitization, amounting to EUR 70 million, benefits from a government guarantee but fiscal risks are mitigated by a 20% escrow account. Morningstar DBRS does not rule out further transactions and does not anticipate a material increase in impaired assets over the medium term, despite the recent shocks. However, NPLs remain very high, hinder the banking sector's capacity to provide credit, and place banks in a more vulnerable situation.

Liquidity in the banking system is improving, with the liquidity position up to seven days above EUR 1 billion (25% of total assets) at end 2023, which is almost twice what it was in June 2018. Moreover, in the event of liquidity pressure, the banking system could benefit from a EUR 100 million repo credit line to the Central Bank of San Marino from the European Central Bank. Although asset quality in the banking system has improved, Morningstar DBRS continues to view the capacity of the central bank to act as lender of last resort to some extent hindered by the fact that San Marino has adopted the euro as its national currency but is not a member of the euro system. This factor, including weaker statistics availability for the financial system compared with peers and the fact that the bank resolution framework is not still aligned with European standards, contributed to Morningstar DBRS' negative adjustment on the "Monetary Policy and Financial Stability" building block assessment.

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

After rising by almost 24 percentage points to 81.3% of GDP in the 2020-21 period, mainly as a result of the government's rescue package provided to the financial system and the fall in economic activity, the public debt has consistently declined to an estimated 73.4% in 2023. The country's high level of public sector debt constrains the government's fiscal space and leaves the economy vulnerable to shocks, but it is expected to continue to fall to around 66.4% of GDP by 2026. Morningstar DBRS does not anticipate further sizable bank support in the near term, but it does not rule out the materialisation of contingent liabilities stemming from the financial system in the future. This could negatively affect the public debt trajectory.

San Marino's government debt profile mitigates the risks associated with higher interest rates, but it is highly exposed to rollover risks. The country's public sector debt has relatively long maturities, and only about 6.0% was at a variable rate by the end of 2023. Moreover, around 42% of the country's debt is nonmarketable with low funding costs and long maturities, which makes public debt largely resilient to volatile interest rates. Morningstar DBRS views also positively the increase in government deposits, which since 2023 have averaged at above EUR 100 million (5.5% of GDP), more than twice the average registered in the 2013-19 period. However, San Marino is highly exposed to refinancing risks when a high 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, even though the government aims to improve the liquidity in the secondary market as well as to reduce the amount of perpetual debt. These factors lead to a negative adjustment to the "Debt and Liquidity" building block assessment.

A Sound External Position Mitigates Risks of Capital Outflows Due to Possible Interest Rates Differentials

San Marino's credit ratings benefit from a sound external position, reflecting dynamic exports and a sizable net foreign asset position. On the other hand, a high reliance on Italy's import demand, accounting for almost 84% of San Marino's total goods exports, makes export diversification very low and the country highly dependent on Italy's economic performance. Higher interest rate differentials might generate 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 swiftly, with 7% more tourists in 2023 compared with 2019. San Marino has been posting current account surpluses since 2019, reflecting an improvement in its cost competitiveness as well some supply disruptions affecting export competitors. In 2023, the surplus is estimated by the IMF to have remained sizable at 4.1% of GDP, though halved compared with 2022, as a result of higher imports and lower external demand. Although San Marino's export performance is expected to remain solid, leading to a projected current account surplus above 2% of GDP in the 2024-26 period, weaker growth in Italy might affect the country's export demand.

Despite the significant fall in the net foreign asset position by more than 20 percentage points in 2023, as a result of the securitization and the large cancellations of an amount of NPLs fully provisioned, at 98.5% of GDP, it remains very high. This still reflects 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 foreign exchange reserves declined from their peak of USD 887 million in 2021 to USD 772 million at the end of 2023.

San Marino's Political Continuity 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 typically is conducive to policy continuity, reducing regulatory uncertainty. The country also has robust World Bank worldwide governance indicators, but the reform effort appears to be slow and this affects the capacity to address economic challenges. As a result, Morningstar DBRS applied a negative adjustment to the "Political Environment" building block assessment. Snap elections in June could see the two main coalitions "Democrazia e Liberta'" and "Coalizione libera/PS-PSD" forming a government rapidly. Although incentives for a significant fiscal consolidation appear moderate, due to the improvement in public finances, Morningstar DBRS does not anticipate a change in the conservative fiscal stance from the next government.

Morningstar DBRS views positively the upcoming Association Agreement between San Marino and the EU, expected to be effective beginning 2025. This would improve economic integration with the EU by enabling the country to have access to the EU internal market. Moreover, while the industry sector will benefit mainly from less red tape and trade barriers, the financial sector, whose integration is likely to be gradual and subject to an audit of its regulatory and supervisory framework, could attract foreign investors and enable San Marino's financial companies to expand business in the EU.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

ESG Considerations had a relevant effect on the credit analysis.

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factors that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
Morningstar DBRS 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 reform effort appears slow and the banking resolution framework is not aligned with EU standards. Morningstar DBRS 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 Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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 at: https://dbrs.morningstar.com/research/433848/.

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://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition, Morningstar DBRS uses the Morningstar DBRS 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://dbrs.morningstar.com/about/methodologies.

The sources of information used for these credit ratings include IMF (World Economic Outlook - April 2024, IFS, Republic of San Marino: 2023 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of San Marino - November 2023), Central Bank of San Marino, Ufficio informatica, tecnologia dati e statistica, Segreteria di Stato per le Finanze e il Bilancio di San Marino, World Bank, Nomisma, Central Bank of San Marino, Prospectus Bond Emission EUR 350 million May 2023, Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

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: YES
With Access to Management: YES

Morningstar DBRS does not audit the information it receives in connection with the 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. Morningstar DBRS' outlooks and credit ratings are under regular surveillance.

For further information on Morningstar DBRS 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 Morningstar DBRS 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://dbrs.morningstar.com/research/433847/.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Carlo Capuano, Senior Vice President, Sector Lead, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: 1 December 2023
Last Rating Date: 1 December 2023

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