NEW YORK--(BUSINESS WIRE)--Strong inflationary pressures continue to test Colombia's commitment to preserving the credibility of its inflation targeting regime and supporting the external accounts' adjustment to low oil prices, Fitch Ratings says.
Inflation rose to 8.40% on annual basis in May 2016, the highest level since 2001 and significantly above the central bank's inflation target of 3%, plus or minus 1%. Inflation pressures are partly driven by rising food prices and the Colombian peso's depreciation. Though these factors could ease in coming months, core inflation and inflation expectations have also increased significantly above the target range.
In its last policy meeting in late May, Banco de la Republica increased its policy rate by 25 bps to 7.25%, following a surprising April increase of 50 bps. Rates have risen by 225 bps since the current tightening cycle began in September 2015. Fitch expects monetary policy will remain focused on bringing headline inflation and expectations under control and supporting the reduction of external imbalances.
Higher interest rates are also likely to support Colombia's adaptation to lower oil prices. The current account deficit rose to a record high of 6.5% of GDP in 2015 on the collapse in oil exports. Colombia's economy expanded by 2.5% year-on-year in first-quarter 2016 in line with Fitch's expectation of more moderate growth in 2016 (2.3%, down from 3% in 2015). Tighter monetary and fiscal policies, a weaker peso and some replacement of imports with domestic production could support a gradual reduction in the current account deficit which remains a source of vulnerability.
Colombia has demonstrated significant exchange rate flexibility, supported by its credible inflation-targeting, a robust financial system and limited FX mismatches in the economy. While oil prices have been a key factor behind the trajectory of the Colombian peso (falling relative to the US dollar by 37% over two years), volatility in financial markets and weakening of EM currencies have recently renewed depreciating pressures.
The factors that underpin Colombia's capacity to absorb external shocks and maintain macroeconomic and financial stability include its track record of targeting inflation, its flexible exchange rate and its healthy banking system. These factors also constitute a key credit strength in the sovereign's credit profile. Colombia's flexible and credible macroeconomic policy framework has underpinned the country's ability to absorb the fall in oil prices over the past two years without macroeconomic destabilization. However, an orderly and sustainable reduction in external and fiscal imbalances represents a policy challenge for authorities to reduce vulnerabilities and stabilize the deterioration of key credit metrics, such as external and fiscal indebtedness.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.