Associated Press

The key issue in Washington that could roil financial markets and the economy isn’t a government shutdown, but rather the failure of the U.S. government to raise the country’s debt limit.

That viewpoint comes from a new report by Moody’s Investors Service unveiled on Tuesday. And it comes at a time when stocks are sliding as the wrangling in Washington moves into forefront of investor attention.

Here’s the key paragraph from the rating firm’s report that’s generating some attention this morning:

“Our expectation is that the US will avoid a shutdown and will increase the debt limit. However, if either (or both) of these deadlines pass without legislative action, the consequences for the economy and government revenues would be negative. A failure to raise the federal debt limit would have greater adverse financial market and economic consequences than a government shutdown because market participants would perceive an increased probability of sovereign default.”

Congress has until Sept. 30 to pass a federal budget, or else the government will shut down. In addition, the U.S. Treasury is set to bump up against its $16.7 trillion borrowing limit around mid-October, unless legislators move to raise the debt ceiling.

If the government were to shutdown, here’s how Moody’s predicts the situation would play out:

“If a shutdown occurred, the government would still service its debt, but like the late-1995- early-1996 government shutdown, we would expect most federal employees to be unpaid and not to work. In fact, on 17 September, Office of Management and Budget Director Sylvia Burwell instructed federal executive department and agency heads to make contingency plans for a federal government shutdown. Government revenues would be adversely affected by the ensuing slowdown in economic activity, a credit negative.”

To be sure, Moody’s anticipates that a government shutdown will be avoided and the debt limit will be increased. But here’s what Moody’s says could transpire in a worst-case scenario:

“Financial market and economic consequences would likely be more severe if the debt limit is not raised than under a government shutdown. Although the expenditure reduction cut under the debt limit scenario is smaller, the perception that the US government could default on debt servicing if the debt limit isn’t raised could roil financial markets and damage business and consumer confidence.”

Moody’s gives the U.S. its top sovereign rating of triple-A, with a stable outlook. The firm raised its outlook on the U.S. rating from negative two months ago, citing an improved forecast for the U.S. government’s debt trajectory.

Fitch Ratings also rates the U.S. at triple-A, although with a negative outlook. Standard & Poor’s Ratings Service has the U.S. at double-A-plus, one notch below the top rating, with a stable outlook.

–Nicole Hong contributed to this report.