By Anthony Boadle
BRASILIA (Reuters) - President Michel Temer's decision to throw in the towel on reforming Brazil's loss-making pension system leaves the unpopular measure as a campaign issue for October's elections and a major headache for his successor.
Monday's announcement that Temer was abandoning an overhaul of the social security system - billed as the centerpiece of his efforts at fiscal reform - sparked immediate concern from credit rating agencies that Latin America's largest economy was failing to put its financial house in order.
Brazil's generous pension system is at the heart of budget deficit that ballooned from 3 percent of GDP in 2013 to a massive 10 percent in 2015, before edging back to 8 percent last year as the $1.8 trillion economy emerged from recession.
The official reason for dropping the pension bill was a military intervention in crime-plagued Rio de Janeiro state, decreed on Friday after unprecedented violence during Carnival. Constitutional amendments such as the pension bill are blocked during federal intervention of a state. [nL2N1Q60BQ]
Deploying the army in Rio will go down well with voters in a nation where polls show public safety is the top concern. Brazil has 60,000 murders a year and its cities are among the world's most dangerous.
Temer's critics, however, said he merely found a pretext to avoid acknowledging an embarrassing defeat.
While Temer, 77, came close to the super majority needed to pass the bill last year, he lost political capital fighting off corruption charges and the government soon discovered it had run out of time, as lawmakers seeking re-election this year refused to back the unpopular legislation.
"Now the government does not have to admit it lost the battle for pension reform," said Fabio Sousa, a congressman for the centrist Brazilian Social Democratic Party, which backed the reform.
"The next president will have to do the fiscal adjustment, which is fine, because he will have a mandate from voters to do something about it," Sousa said in an interview. "The good thing is that pension reform will now be an election campaign issue."
Temer, a former vice president, replaced impeached leftist Dilma Rousseff in 2016. But he has single-digit approval ratings that rule out a presidential bid of his own.
Brazilian markets were stable on Tuesday, with Sao Paulo's BOVESPA stock index gaining 1.2 percent in mid-afternoon as investors had largely expected an already watered-down pension reform to sink in Congress.
In an effort to reassure investors, Temer's cabinet on Monday announced plans to accelerate 15 other policies - ranging from tax breaks to privatizing Brazil's largest utility and strengthening the central bank's autonomy.
Yet Moody's Investors Service promptly warned on Tuesday that the government's pension decision was credit negative and would restrict its ability to comply with a spending ceiling approved last year.
The government is expected to meet its 2018 deficit target but it is doubtful it can do so in 2019, as a sluggish recovery from Brazil's worst recession on record has left tax revenues struggling.
According to the main industry lobby, the CNI, the reform would have saved government coffers about 1 trillion reais ($308 billion) over the next decade.
Brazil's gross public debt already stands at 4.9 trillion reais ($1.5 trillion) or 75 percent of GDP - relatively high for an emerging economy. Without steps to reduce heavy mandatory spending, it will continue climbing, said Felipe Salto, head of the Independent Fiscal Institute, a bipartisan Senate office that aims at transparency in government accounts.
Government projections have the debt stabilizing in 2020 at 80 percent of GDP, but without pension reform that is in doubt.
"You have to show investors it will stabilize. If there is no horizon of stabilization, the market will see a risk of insolvency and higher interest rates will be needed to finance a snowballing debt," Salto said.
($1 = 3.2455 reais)
(Writing by Anthony Boadle; Editing by Tom Brown)