The FTSE 100 index ended nearly 48 points lower at 6,101.2. The quarter- point UK interest-rate cut had no impact.
In New York, the Dow Jones Industrial Average was down 118 points at one stage but recovered sharply as banking shares rallied, to end the day 7.21 off at 9537.76. On top of the Brazil upset, the noted Wall Street bull, Abby Cohen of Goldman Sachs, reduced her recommended portfolio weighting for US shares yesterday.
Other major markets also blamed Brazilian jitters. In Frankfurt share prices fell by 2 per cent, partly reversing their near-9 per cent gain since the launch of the euro.
In Rio de Janeiro, the Bovespa share index had dropped 6 per cent by lunchtime. It finished the day 5.13 per cent down at 6,954. Emerging market bond prices fell across the board, with investors still bearing the scars of Russia's debt default last summer.
The markets were reacting to the announcement by Itamar Franco, new governor of the Brazilian state of Minas Gerais and a likely future presidential candidate, that the state would halt interest payments on its debt to the federal government for 90 days. Although the statement was interpreted as posturing for domestic political purposes, the state is due to make payments on Eurobonds worth $200m within the 90-day period.
The Brazilian government is already mired in a mammoth political battle to push budget cuts through the Congress. The lower house has already delivered one blow to the international rescue package: last month it rejected the first part of the government's plans to get its budget deficit under control.
As a result, capital flows out of the country accelerated to reach more than $5bn in December, surpassing the funds the IMF had pumped in during the month. Until yesterday the outflows had slowed down since the start of the new year, but analysts are sceptical that the deficit reduction package will be passed.
If the government does not win the political battle, further tranches of the international loans could be at risk.
"It's a close call," said David Lubin at HSBC Markets. He said investors might not be prepared to wait as long as Brazil needed to see the fruits of its economic reforms.
Paul McNamara, emerging markets economist at Julius Baer Investments in London, said: "A lot of people appear to have taken leave of their senses in the way money is continuing to pour into some of these emerging markets."Reuse content