UPDATE 2-Paulson warns U.S. govt to reach debt limit Oct 1

(Adds details, comment from U.S. Senate majority leader)

By David Lawder

WASHINGTON, Sept 19 (Reuters) - U.S. Treasury Secretary Henry Paulson warned on Wednesday the federal government would hit its $8.965 trillion debt limit on Oct. 1 if Congress fails to increase borrowing authority, adding to financial market worries.

Paulson, in a letter to congressional leaders, urged quick Senate approval of a bill that would raise the debt limit by $850 billion.

"The full faith and credit of the United States, to which we all remain committed, is a national asset and a cornerstone of the global financial system," Paulson wrote.

"In light of current developments in financial markets, which would be exacerbated by uncertainty in the Treasuries market, I urge the Senate to pass the legislation reported by the (Senate) Finance Committee to increase the debt limit as soon as possible," he wrote.

The finance panel last week approved an increase in the federal debt limit to $9.815 trillion, matching a credit increase approved by the U.S. House of Representatives earlier this year.

Votes to raise the debt limit have been politically unpalatable, but neither Democrats nor Republicans have voiced intentions to try to block this year's request.

The increase is expected to be large enough to allow the government to continue borrowing into 2009, well after next year's presidential and congressional elections.

"We are very aware of the (Bush) administration's request to increase the debt limit for the fifth time since it took office," said Jim Manley, a spokesman for Senate Majority Leader Harry Reid, a Nevada Democrat. "Senator Reid intends to do so as quickly as possible and hopes Senate Republicans will cooperate," he said.

The Bush administration has estimated this year's budget deficit would total $205 billion, down from $248 billion last year. For fiscal 2008, it expects the deficit to swell to $258 billion and then shrink again before reaching a surplus in 2012.

As of Tuesday, the federal debt stood at $8.924 trillion, about $41 billion below the limit. Paulson had previously estimated the debt limit would be breached in early October, but based on estimated September's corporate and individual income tax payments, he said this would now occur on Oct. 1.

The Treasury can take a number of emergency measures to stay under the the debt limit for a period of time if the Senate fails to increase the debt limit.

These include temporarily diverting money from several federal employee pension and disability funds and dipping into the Exchange Stabilization Fund, a seldom-used pool of money earmarked to stabilize currency rates. The Treasury also can suspend issuance of debt securities to state and local governments and sell more short-term cash management bills to gain more precise day-to-day control over federal finances.

Paulson has expressed reluctance to resort to such measures, saying they could create unnecessary uncertainty for financial markets already rocked by U.S. housing woes and a credit squeeze.

For more details on the Treasury's options to stay under the limit, please click on [ID:nN19327812]. (Additional reporting by Donna Smith)