North American markets sell off sharply amid worries about the effects of a failure on the part of the U.S. to raise its debt limit.

The S&P/TSX composite index closed down for a third session Wednesday, losing 267.89 points, or two per cent, to 13,032.67.

The United States has until Aug. 2 to reach a deal to increase its $14.3 trillion US debt limit or face not being able to pay its bills.

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S&P/TSX 1-year chart

That has led to fears the country could default on its financial obligations, which could send shockwaves through financial markets.

Even if a deal is reached, there are fears the U.S. could still lose its top credit rating, which would lead to much higher interest payments.

"When there is this much uncertainty, why would you stick your neck out," said Ian Nakamoto, director of research at MacDougall, MacDougall and MacTier.

"The markets are sending a pretty clear message to the politicians. If the markets are ho-hum and didn't react, the politicians wouldn't act. When the financial markets send a message to get your act in order, they have to respond."

Selling accelerated after the U.S. Treasury released a statement saying that after Aug. 2 there was no way to guarantee the government would be able to meet all of its obligations.

Dow down for fourth day

The Dow Jones Industrial Average fell for the fourth straight day, down 198.75 points, or 1.59 per cent, to 12,302.55. The Nasdaq composite index lost 75.17 points, or 2.65 per cent, to 2,764.79 while the S&P 500 index was down 27.05 points, or 2.03 per cent, to 1,304.89.

BMO Financial's chief economist, Sherry Cooper, said markets have begun pricing in the likelihood in the "near future" of a downgrade of the U.S. government's triple-A rating by bond rating agencies of one notch.

"Although relatively few think the government will technically default," she said in a commentary, "Interest rates have risen across the Treasury yield curve. The yield on August 4 T-bills this morning jumped to nearly 0.12 per cent, more than doubling in a sign of growing anxiety."

Cooper said businesses are responding to the possibility of higher interest rates by reducing risk and raising cash.

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Dow Jones Industrial Average 1-year chart

"Cash balances, which were already very high in the corporate world, are rising further," she said.

"Banks, in particular, fearful of rising costs in the (short-term debt) market, are hoarding cash and nonfinancial businesses are preparing alternative non-market sources of funds, a continuation of a trend that began with the Lehman crisis in 2008."

"Business will reduce spending to maintain high levels of cash.  Hiring and capital spending plans are at risk of postponement or cancellation.

Consumers and investors are behaving more cautiously as well, which is bad for an economy that was already at risk of a sustained period of slower growth, she said.

In overseas trading, Tokyo's Nikkei 225 stock average closed 0.5 per cent lower, South Korea's Kospi edged up 0.3 per cent while Hong Kong's Hang Seng Index fell 0.1 per cent.

China's Shanghai Composite Index gained 0.8 per cent and the smaller Shenzhen Composite Index gained 1.7 per cent.

European markets declined as London's FTSE 100 index lost 1.23 per cent, Frankfurt's DAX was down 1.32 per cent and the Paris CAC 40 declined 1.42 per cent.

With files from The Canadian Press