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Brazilian stocks fell sharply on Friday as the arrest of the country's former president, Michel Temer, sparked worries that government debate over key fiscal reforms may be delayed.
The iShares MSCI Brazil ETF (EWZ) dropped 6 percent and posted its worst day since May 18, 2017, when it fell 16.3 percent. The Bovespa index, Brazil's benchmark index, fell about 3.3 percent after hitting an all-time high earlier this week.
Temer was arrested in Sao Paulo on Thursday, with prosecutors alleging he was the head of a "criminal organization" that took more than $470 million in bribes or kickbacks.
Temer already faced ongoing criminal investigations against him before leaving the presidency. However, his arrest comes as current President Jair Bolsonaro tries to push forward major changes to the country's pension system, which investors largely bet will happen.
"The key question is whether or not his arrest affects pension reform. In theory it shouldn't," Dirk Willer, head of emerging market strategy at Citigroup, said in a note. However, "the period between the unveiling of the pension reform and approval by the special house committee will be filled with much noise and headline risk. [Thursday's] news was a good example of the sort of headline risks one should expect over the next months when pension reform makes its way through congress."
Brazilian stocks surged to start the year amid hopes the Bolsonaro administration would pass key changes to the country's social security system. Brazil's generous pension system effectively lets citizens retire in their 50s. This has led to massive government debt, which has stymied consistent economic growth in Brazil.
But while investors are still betting on some sort of reform taking place, they are realizing it could be a bumpy ride. On Wednesday, Bolsonaro unveiled a military pension reform plan that would save just $265 million on average over the next 10 years. These savings are well below those proposed by the country's Economic Ministry.
But it is key for Bolsonaro's broader pension-reform efforts as lawmakers indicated they could not debate the matter until they saw the president's plans for military pensions.
Now, Temer's arrest could delay that process even further depending on how his party — which holds 34 seats in the lower house — reacts, Citi's Willer said.