OREANDA-NEWS. Colombia's interest rate rise illustrates the authorities' commitment to macroeconomic stability in their policy response to lower oil prices, Fitch Ratings says. A credible policy framework has allowed the peso depreciation to cushion the external shock to the economy, but fiscal challenges may prove tougher.

Colombia's central bank increased the benchmark rate for the first time in over a year on Friday, by 25bp to 4.75%. The bank cited rising consumer price inflation - which at 4.74% in August was above the 3% plus or minus 1pp target - and the risk of unanchored inflation expectations due to peso devaluation and supply side factors such as El Nino pushing up food prices.

The rate increase bolsters our view that macroeconomic policy consistency and flexibility will help Colombia navigate the fall in oil prices. The peso's drop of more than 50% against the dollar in the last year will help reduce Colombia's external imbalances (the current account deficit was 5.5% of GDP in 2Q15).

Colombia's significant exchange rate flexibility partly reflects its strong starting point due to the central bank's inflation-targeting credentials (inflation averaged 2.8% and was rarely outside the target range from 2010-2014), alongside financial system robustness and limited FX mismatches in the economy. Unlike some of the other central banks in the region, the Colombian central bank has not intervened by selling dollars in the FX market. Moving to counter the exchange-rate pass through effect from peso depreciation signals that the central bank is mindful of the need to preserve macroeconomic stability and policy credibility.

But an external shock on this scale will continue to present policy challenges. Fiscal accounts are vulnerable to lower growth (we forecast real GDP growth to slow to 2.7% this year, from 4.5% in each of the last two years) and falling oil-derived revenues, which could drop to 1.2% of GDP this year from 3.3% in 2013. A narrow revenue base and a rigid expenditure profile constrain fiscal flexibility. The government has cut spending for 2015 and 2016, but, the central government deficit is still projected to rise to 3.0% of GDP this year and 3.6% next year under the government's Fiscal Rule parameters, from 2.4% in 2014.

Reining in the fiscal gap and stabilising debt levels are unlikely without further spending cuts and revenue-generating measures. General government debt is projected to reach 43.5% of GDP in 2015, slightly above the 'BBB' median. Implementing a peace agreement with FARC rebels (which appeared to draw closer following agreement on a formula for transitional justice last week) could further challenge medium-term fiscal consolidation.

We affirmed Colombia's 'BBB'/Stable sovereign rating in May. The rating reflects the sovereign's flexible and credible policy framework, external buffers and relatively strong growth, set against commodity dependence, limited fiscal flexibility, structural and governance constraints, and a deteriorating external environment.