SAN MARINO (AP) — The tiny mountaintop republic of San Marino long served as a tax haven for Italians. Now it is watching helplessly as its neighbour's hard line on undeclared funds drains it of billions in capital.

In all, 1.25 billion euros ($1.87 billion) has been withdrawn from accounts in San Marino — an enclave in northeast Italy near the Adriatic coast — since Italy announced a tax amnesty in October for scofflaws hiding income abroad, according to Finance Minister Gabriele Gatti.

The amnesty threatens to deepen San Marino's recession and is creating worries about the future of its lucrative banking industry, which grew behind a veil of banking secrecy to represent 18 percent of the country's economy.

The aggressive approach taken by Italy — which is allowing undeclared holdings to be legalised for a negligible penalty of 5 percent — has brought turmoil to the otherwise placid and prosperous mountaintop republic overlooking the Adriatic Sea. The Italian action comes at a time when all tax havens, from banking powerhouse Switzerland to Caribbean island and fiscal paradises, are under pressure by the Group of 20 largest economies to make their banking systems more transparent to tax authorities.

Tourists are drawn to San Marino for the novelty of its size — just 23 square miles — to wander up to the medieval castle on the mountaintop and shop its cobbled streets for tax-free goods. Many pay five euros for a passport stamp just to prove they were there. But it was its status as a fiscal paradise that created the greatest allure for individuals seeking a place to hide their money from the domestic taxman — and for entrepreneurs who sought tax rates lower than those in surrounding Italy. Industry is San Marino's main economic engine, from ceramics to furniture to animal feed.

"We want to have a transparent economy. We don't want the frauds there were in the past. Rather than people coming here to dodge tax, we need people to come and create jobs," said former Justice Minister Ivan Foschi, who is an opposition member of parliament.

But even that is under attack, said Foschi, with Italian financial police accusing San Marino businesses of evading Italian taxes.

"This, for a little state like San Marino, is worrisome," he said.

San Marino's economic contraction is expected to widen to 4.1 percent from an earlier estimate of three percent, due largely to the impact of the Italian measure, according to calculations by the European House-Ambrosetti consulting firm. The drag on economic output could reach 7.3 percent if withdrawals reach more drastic levels of 2.2 billion to 4.5 billion euros, with the amnesty's full impact to hit in 2010.

As a result of the amnesty, Fitch Ratings has downgraded the Republic of San Marino's long-term credit rating to "A" from "AA-." Fitch said the Italian tax amnesty threatens "the country's business model".

Rebuilding San Marino's economy will mean reinventing the financial industry to meet new international standards for transparency, according to Valerio de Molli, an analyst at e European House-Ambrosetti, which has just published a study on San Marino's economy.

But it also should mean exploiting its own uniqueness, namely promoting tourism, "to rebalance the situation", de Molli said.