UPDATE 5-Chile markets plunge after government hammered in constitution vote

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By Dave Sherwood and Karin Strohecker

SANTIAGO/LONDON, May 17 (Reuters) - Chile's markets plunged on Monday after voters propelled leftist and independent groups to victory in an election over who will draft a planned new constitution, a major blow to the center-right ruling coalition that fared far worse than expected.

The copper-producing country's bonds, currency and stocks all sank as investors worried that there may be a major overhaul of Chile's market-friendly constitution, dating from the dictatorship of Augusto Pinochet.

"This was a clear rejection of established political parties," said Nathalie Marshik, who focuses on Latin America at brokerage and investment banking firm Stifel, adding it raised uncertainties and could weigh down sovereign bonds.

Chile has long been a poster child for economic stability in volatile Latin America, but more people angry about inequality have been attacking the neo-liberal model seeded by the 'Chicago Boys' group of U.S.-influenced economists in the 1970s and '80s.

Violent protests in 2019 saw buildings and metro stations burn, lighting the touch paper for the shift towards a new constitution. The government has also been forced to allow early withdrawals from Chile's once-revered private pension system.

In the weekend vote, the center-right conservative parties failed to secure a critical one-third of seats in the body that will draft the new constitution over the next year. That means they lack the votes to veto radical proposals.

With 90% of votes counted on Sunday, candidates backed by President Sebastian Pinera's Chile Vamos coalition had won only a fifth of seats. Independents picked up the most votes.

Pinera said his government and other traditional political parties should heed the "loud and clear" message that they had not adequately responded to the needs of citizens. Chile, one of the wealthiest, most stable democracies in Latin America, will hold a general election in November.

The IPSA stock index tumbled nearly 10% before recouping some losses to trade down around 8%, its biggest daily drop since the COVID-19 pandemic ripped through global financial markets in March 2020.

Chile's peso weakened as much as 3.6% to touch a 1-1/2-month low before clawing back some ground.

Dollar-denominated sovereign bonds fell , and the premium demanded by investors to hold Chilean debt over U.S. Treasuries widened.

Chile 5-year credit default swaps, which reflect the cost to insure against a sovereign default, jumped by 7 basis points to 61 bps, the highest since October, Refinitiv data showed.

'DECISIVE BREAK'

The weekend vote to pick 155 citizens to rewrite the constitution was borne from fierce protests that erupted over inequality and elitism in October 2019. The current constitution is widely viewed as favoring big business over ordinary citizens.

"It is clear that Chileans want to make a decisive break with the Pinochet-era constitution, which is a great idea, but it is not quite clear where Chileans want to go," said Jan Dehn, head of research at asset manager Ashmore Group.

"The only thing that looks likely is that Chile will have a larger welfare state. Chile can afford this."

Goldman Sachs said in a note the center-right coalition had been "politically debilitated" and it expected the new constitution to be in favor of a "larger, more interventionist state and the broadening of the social safety net".

"This would add further pressure on the already deteriorating fiscal/debt dynamics, and a potential shift away from hitherto investment-friendly policies and institutions could weigh on medium-term macroeconomic performance," it added.

New proposals, possibly including changes to private land and water rights as well as employment legislation, would require two-thirds approval. Without a third of the delegates, the government will struggle to block changes.

JPMorgan's Diego Pereira wrote in a note to clients that the outcome suggested "a regime of heightened uncertainty ahead". (Reporting by Karin Strohecker and Tom Arnold in London, Dave Sherwood and Froilan Romero in Santiago; Additional reporting by Rodrigo Campos in New York; Writing by Adam Jourdan; Editing by Marguerita Choy, Alex Richardson and David Gregorio)