Brazil stocks plunge on emerging political scandal, post worst day since 2008

• The Brazilian Bovespa traded more than 8.5 percent lower, while the widely followed iShares MSCI Brazil Capped ETF (EWZ) dropped more than 13 percent.
• Both indexes were on pace for their worst day since October 2008.
• Brazilian newspaper O Globo reported late Wednesday that Brazilian President Michel Temer gave his blessing to an attempt to pay a potential witness to remain silent in the country's biggest-ever graft probe.

Brazilian stocks dropped 8.8 percent Thursday on an emerging scandal involving the country's recently installed president.

The Brazil Bovespa index recovered from an opening decline of more than 10 percent, but still logged its worst day since Oct. 22, 2008.

The iShares MSCI Brazil Capped ETF (EWZ), a heavily traded U.S. exchange-traded fund that tracks Brazilian stocks, closed 16.3 percent lower after earlier falling more than 18 percent. The ETF also posted its worst day since October 2008.

Less than 10 months into President Michel Temer's administration, Brazilian newspaper O Globo reported late Wednesday that Temer gave his blessing to an attempt to pay a potential witness to remain silent in the country's biggest-ever graft probe.

Brazil's top court opened a probe on Temer, Bloomberg reported in early Thursday afternoon trade, citing GloboNews.

Temer said Thursday afternoon that he will not resign and he will prove his innocence in the Supreme Court, according to a Reuters report.

"The moves in Brazilian assets this morning reflect a concern from investors that with these new political headlines much needed reforms will be unable to pass," Gabriela Santos, vice president, global market strategist, at JPMorgan Asset Management, said in an emailed response to CNBC from Brazil.

"Many local and foreign investors were positioned in Brazil with reform approvals as the base case, and thus had a pro risk bias. As result, we are seeing some unwinding in positions this morning," Santos said. She remains positive on emerging markets overall on expectations of better growth, especially in China.

EWZ year-to-date performance

Source: FactSet

Temer's office on Wednesday acknowledged he had met in March with the businessman, Chairman Joesley Batista of meat giant JBS SA, but denied any part in alleged efforts to keep jailed former House Speaker Eduardo Cunha from testifying.

O Globo's report, which they say three sources familiar with the matter said was accurate, threatened to pull Temer into a corruption scandal that has already entangled several of his closest allies and advisors.

"We believe the administration's economic team is highly concerned the crisis will impact their reform agenda," Larry McDonald wrote Thursday in "The Bear Traps Report" newsletter. "Equity prices / valuations are very dependent on completion / passage of these reforms."

U.S.-listed shares of major Brazilian stocks plunged:

• State-run Petrobras dropped more than 15.4 percent.
• Banco Bradesco fell more than 13.4 percent.
• Vale SA recovered from a roughly 8 percent decline to close about 0.4 percent higher.
• Itau Unibanco fell 12.1 percent.

The iShares MSCI Emerging Markets ETF (EEM) closed off session lows, down 1.66 percent.

Brazil makes up 7.43 percent of the MSCI Emerging Markets Index, as of April 28. China is the country with the greatest weighting, at 27.05 percent.

Argentina's Merval stock index closed 2.95 percent lower in its worst day for 2017. Argentina, which defaulted on $1.3 billion in debt in 2014, trades the most with Brazil.

The Brazilian real fell more than 7.5 percent against the U.S. dollar Thursday.

The opening drop in the Brazilian stock market triggered a circuit breaker on the Bovespa exchange, Bloomberg reported.

Brazilian equities have surged over the past year, with the EWZ rising more than 45 percent in the period, as investors cheered Temer's proposed economic policies. The fund is one of the 20 most actively traded ETFs in the U.S. market on a daily basis, on average.

EWZ closed 19.7 percent below its 52-week high hit on Feb. 23, just shy of bear market territory.

"Brazil blows up every couple years," Tim Seymour, managing partner of Triogem Asset Management, said in an email. It "got overcrowded for regional dedicated players."

The country's stocks are about "8 percent of the EM index and taking EM down today more than it might," Seymour said. "That creates an opportunity but think about the politics across EM right now."

The new president and his promised reforms were supposed to turn the page on Brazil's rocky political climate. Temer became leader of the country after President Dilma Rousseff was removed Aug. 31 amid a massive corruption scandal and an economic crisis that crippled Latin America's largest country.

"Now the fear is that Temer might have to leave office like his predecessor, Dilma Rousseff," said Komal Sri-Kumar, president of Sri-Kumar Global Strategies. "But it's too early to panic, because there are a lot of steps to removing a president in Brazil."

Brazil had been an economic stalwart in the region just a few years before Rousseff's impeachment, buoyed by surging oil prices. But the collapse in the crude market, coupled with a corruption scandal at Petrobras, led to millions of Brazilians flooding the streets in protest of Rousseff's presidency.

— CNBC's Gina Francolla and Reuters contributed to this report.