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

DBRS Ratings GmbH (Morningstar DBRS) confirmed the 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 trends on all ratings are Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects Morningstar DBRS' view that risks to San Marino's credit ratings are balanced. The government will likely maintain a conservative fiscal stance as higher fiscal revenues resulting from a planned tax reform, will contribute to maintain the public debt-to-GDP ratio on a declining trajectory in coming years. Latest projections from the International Monetary Fund (IMF) point to a decline in the ratio to 65.3% by 2026 from 72.2% in 2023. However, public sector debt redemptions, amounting to over 20% of GDP in 2027 remain elevated, even though Morningstar DBRS expects the government to reduce rollover risk through a proactive approach. In addition, legacy contingent liabilities could still put pressure on fiscal accounts, as fiscal policy remains the only stabilisation tool available. However, the banking sector's asset quality has improved, after a sharp reduction in the nonperforming loan (NPL) ratio, and further declines are expected. The upcoming association agreement with the European Union (EU), expected to be effective as of 2026, could attract higher investments and boost the country's economic prospects.

San Marino's credit ratings are underpinned by a relatively high GDP per-capita income, a sizable net external asset position that benefits from the country's dynamic export performance and a large amount of commercial bank assets abroad. Moreover, policymaking is supported by 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 availability. Moreover, the San Marino is a small and open economy exposed 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 and sustained decline in the public-debt-to-GDP ratio, potentially as a result of an improvement in the economic prospects or fiscal position over the medium term; (2) a material improvement in the debt profile; and (3) a successful 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 crystallisation of contingent liabilities, likely stemming from the banking system, causing a significant rise in the public debt-to-GDP ratio.

CREDIT RATING RATIONALE

The Government is Well-Positioned to Implement the Tax and the VAT Reform

Snap political elections held in June 2024 saw the two main coalitions, "Democrazia e Liberta'" and "Coalizione libera/PS-PSD," rapidly forming a government that benefits from an ample majority. This leads to policy continuity, which reduces regulatory uncertainty as well as makes more likely the passing of the income tax and VAT reforms this year and in 2026, respectively. The government aims also to improve the efficiency of the public administration as well as to facilitate further NPL reduction. However, weak administrative capacity along with a slow track record in implementing reforms could weigh on the government's capacity to effectively deliver on its reforms. As a result, Morningstar DBRS applied a negative adjustment to the "Political Environment" building block assessment.

Morningstar DBRS views positively the upcoming association agreement between San Marino and the EU, expected to be effective in 2026. 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. Moreover, the association agreement is expected to foster an improvement in governance, as well as other reforms, which would make the economy more resilient.

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

San Marino is a microstate but enjoys relatively high GDP per-capita income, which the IMF estimated at around USD 60,300 in 2024. Over the past decade, the country's economic model has shifted to a more stable manufacturing and tertiary one from an offshore banking system. This has contributed to enhancing the country's resilience, which has recovered swiftly after the pandemic. However, economic diversification remains limited as it is largely concentrated in the manufacturing sector, which currently accounts for one third of gross value added 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. This factor together with weak structural growth underpins a negative adjustment in the "Economic Structure and Performance" building block assessment.

After two years of strong economic growth, when real GDP expanded on average by 11%, San Marino's economic performance slowed significantly in 2023. Weaker imports from Italy weighed on the country's growth, with real GDP expanding only by 0.4% last year. Low inflation, which has remained below 2% since February 2024, along with the recovery in the industrial sector performance and the boost in tourism, is estimated to have supported GDP growth of 0.7% in 2024. Looking forward, San Marino's real GDP is projected to grow by around 1.3% this year according to the IMF. Nevertheless, over the medium term, upside to economic growth could stem from stronger investments attracted by the benefits of the EU association agreement.

The labour market is strong and will continue to benefit from easy access of cross border workers. Past labour market reforms encouraged many foreign workers to enter San Marino's labour market, which now registers employment at record level and an unemployment rate only slightly above 4.0%. Going forward, job creation will remain moderate in the medium term as the labour market appears tight, even though new opportunities from the impact of the association agreement with the EU could provide further impetus.

Interest Costs Are Weighing on Public Finances, but the Expected Fiscal Reform and Lower Banking Support 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, eased 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 modest deficit of 1.0% of GDP in 2023 and is estimated at similar level in 2024.

Going forward, the fiscal deficit is expected to remain contained thanks to the impact of the pension reform in 2022 as well as the upcoming income tax reform. This is expected to be effective from 2026 and could further reinforce public sector accounts by overhauling tax expenditures and recalibrating the tax base. Moreover, ongoing support to the banking sector will likely decline starting from 2027, generating further room to lower expenditures. The government plans to reform also indirect taxes on imports, which would align San Marino's tax system to other countries. While this would reduce distortions and facilitate the integration with Europe, the impact on public finances could be neutral.

Morningstar DBRS views positively the publication of the government's fiscal strategy, which improves predictability. However, San Marino's public finances remain vulnerable to the potential need to provide further support to the financial system, as fiscal policy is the only stabilisation tool available. Given the legacy vulnerabilities of the banking system, support could be still large and hamper the government's capacity to build a fiscal buffer. 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 capitalisation and liquidity. Moreover, on the back of high interest margins, banks have increased their profitability, while the introduction of the calendar provisioning is a strong incentive to accelerate recoveries and deal with NPLs. Nevertheless, the reduction of operational costs, deferred tax credits and a large amount of assets which do not generate income remain key challenges.

After setting up the Asset Management Company, a securitisation programme, along with the write-off of a large amount of impaired assets, the gross NPL ratio almost halved to 23.7% in December 2023 compared with 56.2% in the same period in 2022. The senior note of the NPL securitization, which benefits from a government guarantee, continues to amortise well and the government guarantee has now declined to EUR 35 million from EUR 70 million. Moreover, fiscal risks are further mitigated by an escrow account amounting to 20% of the senior tranche. Morningstar DBRS does not rule out further NPL transactions and does not anticipate a material increase in impaired assets over the medium term. However, NPLs remain very high at around 24.6% as of June 2024, placing banks in a vulnerable situation. Moreover, the impact of the calendar provisioning could lead to potential losses, requiring further recapitalisations. This could be further exacerbated by expected more moderate profitability as interest rates normalise.

Liquidity in the banking system has improved, with the liquidity position, up to seven days, above EUR 1 billion (25% of total assets) at the end of 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 the weaker availability of data and statistics on the real estate market, the large amount of deferred tax credits, which hampers the quality of banking system capital, and the fact that the bank resolution framework is still not aligned with European standards contributed to Morningstar DBRS' negative adjustment to the "Monetary Policy and Financial Stability" building block assessment.

High Stock of Debt and Sizable Rollover Amounts Make Public Debt Vulnerable, Proactive Debt Management Mitigates Risks

Strong nominal growth and more moderate deficits contributed to a material decline in the public debt ratio, which at an estimated level of 68% of GDP in 2024, was around 13 percentage points lower than the peak in 2021. However, it remains elevated constraining the government's fiscal space and therefore leaving the economy vulnerable to shocks. Looking forward, despite modest economic growth, a prudent fiscal stance will facilitate a further decline in the public debt ratio, which is expected to fall to 65.3% of GDP by 2026. This would make achieving the goal of 60% by 2029 feasible, although challenging. 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 8.0% was at a variable rate by the end of 2024. Moreover, around 57% 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 also views positively the increase in government deposits, which since 2023 have averaged above EUR 110 million (5.9% of GDP), more than twice the average registered in the 2013-19 period. However, public debt redemptions are concentrated, particularly in 2027. 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 assessment. That said, the government aims to improve the diversification of funding, particularly from the internal debt market, through smaller debt issuances, tapping Italy's market or implementing private placement. This would widen the investor base, make the debt more liquid and increase the average maturity, improving the debt profile.

A Sound External Position Supports the Credit Ratings

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 geographical export diversification limited and the country highly dependent on Italy's economic performance.

The export-oriented manufacturing sector has shown resilience, despite the impact of the pandemic and the energy crisis, while tourist arrivals have exceeded pre-pandemic levels, with almost 11% more tourists arriving in the first 11 months of 2024 compared with the same period in 2019. The improvement in its cost competitiveness as well some supply disruptions affecting export competitors has led San Marino to take advantage of the pre-pandemic increased export production capacity. The economy recorded sizable current account surpluses amounting to around 15% of GDP on average in the 2022-2023 period. As construction demand from Italy is petering out, the current account surplus has been moderating. The IMF estimates a surplus of 6.4% of GDP last year and forecasts 4.6% in 2025.

Despite falling significantly by more than 20 percentage points in 2023, because of the securitization and the large write-off of an amount of fully provisioned NPLs, the net foreign asset position remains very high at 96.8% of GDP. Following the outflow of deposits in 2022, resulting from higher yields abroad, international reserves have stabilized, strengthening the external resilience of the economy. According to the IMF, gross international reserves declined from their peak of around EUR 843 million in 2021 to EUR 533 million before increasing again to around EUR 740 million at the end of 2023. Latest estimates point to a slightly lower amount going forward.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
ESG Considerations had a relevant effect on the credit analysis.

Governance (G) Factors

The following Governance factor had a relevant effect on the credit analysis: Institutional Strength, Governance, and Transparency. Compared with other peers, San Marino shows a weaker data availability, particularly in real estate prices, reflecting weak administrative capacity, while the reform effort remains slow. Moreover, the banking system lacks a resolution framework. This factor has been considered in the Monetary Policy and Financial Stability and Political Environment building blocks.

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

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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/447604.

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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 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 (WEO - October 2024, IMF IFS, 2024 ARTICLE IV CONSULTATION--PRESS RELEASE AND STAFF REPORT - December 2024), "Segreteria di Stato per le Finanze e il Bilancio" (Programma Economico 2025 - October 2024, Bilancio in breve - May 2024), World Bank, BIS, "Ufficio infromatica, tecnologia, dati e statistica", Central Bank of San Marino ("Bollettino Informativo Trimestrale" - June 2024), Macrobond. 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 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. 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://www.dbrsmorningstar.com/research/447602.

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: 15 November 2024

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