SAN MARINO (Reuters) - San Marino has seen medieval intrigue and papal army invasions in its 1,708-year history, but a modern-day banking scandal and blitz on tax havens risks bringing the world's oldest republic to its knees.
From its hilltop perch near Italy's Adriatic coast, the offshore banking center just a third of the size of Washington D.C. is battling a concatenation of crises -- capped by a money-laundering scandal at its largest bank -- that has forced a frantic rethink of its financial model.
"We're not going to hide that this is a difficult time for San Marino," Antonella Mularoni, the state's foreign secretary said in her office with 19th-century frescoes on the ceiling.
"It's been a few months of huge difficulties and we clearly need the crisis to blow over rapidly."
Blow after blow have rained on the Most Serene Republic of San Marino in months, leaving the city-state of 31,000 people harder hit than larger offshore rival Luxembourg, according to the Fitch ratings agency which downgraded its sovereign ratings.
First came the credit crunch and ensuing downturn, followed by a global crackdown on offshore centers to fight tax dodging. Arrests of top executives at its most important bank, Cassa di Risparmio della Repubblica di San Marino (CRSM), and a tax amnesty approved by Italy this month completed its misery.
"A climate of uncertainty and mistrust has been generated -- for broader reasons and for reasons specifically related to San Marino -- which is certainly weakening the system," said Biagio Bossone, chairman of San Marino's four-year old central bank.
"Now when one talks of San Marino, it is spoken of badly. It seems as if the world is against us."
Wealth managed in San Marino slipped to about 13.6 billion euros ($19.41 billion) in April from over 14 billion last August, while unemployment has risen as fewer tourists visit to buy the microstate's postage stamps and souvenirs.
Funds paid out to finance temporary layoffs jumped more than six-fold in January-April from a year earlier.
After 3 percent annual average GDP growth from 2000 to 2008 -- which easily outpaced neighboring Italy's sluggish 1.2 percent average in that period -- San Marino's government now expects its economy to contract 10 to 12 percent this year.
Legend has it that San Marino was founded on Mount Titano in the fourth century by a stonemason seeking a refuge for Christians, though lately it enjoys a less altruistic image as a haven for Italians hiding from the taxman.
Recent scrutiny on tax havens and the threat of sanctions by G20 nations have made it clear it can no longer rely on the promise of anonymity to lure capital.
"It was easy for big countries -- they didn't have enough money at home at a time of crisis so they've gone to search where they think the money could be," Mularoni said.
Making matters worse, in May, Italian prosecutors probing money-laundering arrested the top five executives of the CRSM, which local people often just call Cassa.
Italy's central bank then placed the bank's consumer finance group Delta under bankruptcy proceedings, further lifting tensions within the system of 12 banks and 55 financial groups.
Fitch quickly cut the nation's debt ratings to AA-, citing the systemic role played by the Cassa in the economy, growing uncertainty for the bank and a hit to San Marino's reputation.
All this after the enclave had been shoring up controls and last November set up a new agency to combat money-laundering.
"It's a paradox, all this attention has come just when our controls are at their highest," said Nicola Veronesi, director of the state's new Financial Intelligence Agency.
Adding insult to injury, Italy -- which accounts for most of the inflows to the bank system -- has declared its own war on tax havens, launching an amnesty for those bringing back money stored offshore and ruling that money in such centers is evasion unless proved otherwise.
San Marino officials say it is unclear how much wealth the new amnesty could drain away; Fitch analyst Andres Klaar notes the state has successfully weathered previous amnesties.
But with the government relying on the banking sector for about 20 percent of tax revenues -- about half of that from the troubled Cassa alone -- San Marino is bracing for a budget deficit this year and an even tougher 2010, Mularoni said.
An air of foreboding hangs over the state, from its restaurants with checked tablecloths to the dusty vineyards on its slopes. Some ask if San Marino risks collapsing altogether.
"There's no doubt this is the most difficult moment we're facing since World War II," said Renzino Gobbi, who runs the San Marino vintners' consortium from the state's only winery, stacked with large steel vats and small oak barrels.
"There's real worry here. We were already facing a difficult time with the crisis, and now with the Cassa's problems, there's a real question out there about the state's future."
Despite the gloom some top officials, putting on a brave face, hope to reshape the state into a corporate rather than finance hub by luring firms with a low 17 percent tax rate and the prospect of a Southern European base.
Mularoni is rushing to wrap up by September the agreements needed to get San Marino off the OECD's "grey list" of tax havens that have yet to sign the necessary tax agreements.
Down the street in a modern steel and glass building, Bossone is plotting how San Marino's banks can attract capital without the lure of secrecy.
"Sure, it's a huge challenge," he said. "But do we have any other alternative?"
Whatever happens, he says San Marino must look beyond Italian savers and focus instead on drawing businesses, diversifying its financial products and delivering competitive returns.
Some have already begun: the state's second largest bank Banca di San Marino has begun offering new investment funds and more sophisticated financing for clients, says Vincenzo Tagliaferro, its director general.
"We have to become the Scotland of central Italy," he said, referring to investment expertise offered in the Celtic nation.
Fitch says San Marino's future hinges on its ability to build up its international competitiveness, while the central bank's director general Luca Papi says San Marino's small size may be an asset in the post-crisis world.
"We don't expect to compete with Luxembourg or Ireland," Papi said. "It would be enough for us to intercept a small slice of the money that goes to Luxembourg or Ireland."
Editing by Sara Ledwith