California's lawmakers failed to agree on a balanced budget by the start of its new fiscal year on Wednesday morning, clearing the way to suspend payments owed to the state's vendors and local agencies, who instead will get IOU notes promising payment.

The notes will mark the first time in 17 years the most populous U.S. state's government will have to resort to the unusual and dramatic measure.

Democrats who control the legislature could not convince Republicans late on Tuesday night to back their plans to tackle a $24.3 billion budget shortfall or a stopgap effort to ward off the IOUs. The two sides agree on the need for spending cuts but are split over whether to raise taxes.

Democrats have pushed for new revenues while Republican lawmakers and Governor Arnold Schwarzenegger, also a Republican, have ruled out tax increases. They instead see deep spending cuts as the solution to balancing the budget, but Democrats say that would slash the state's safety net for the needy to the bone.

Tempers flared in the state Senate as the midnight start of the new fiscal year neared.

There is no excuse to hold this whole state hostage, state Senate President Pro Tem Darrell Steinberg told Republicans during a floor debate.

Senate Republican Leader Dennis Hollingsworth countered that major cuts are urgently needed. Otherwise, There will be entire programs that will have to be lopped off, he said.

CASH CRISIS LOOMS

California lawmakers struggle with budget deadlines practically every year, but this year's budget fight is taking place amid the state's worst drop in revenues from personal income taxes since the Great Depression as recession and rising unemployment pile on to the damage done to the state's economy from its long housing slump.

Because of its steep revenue decline, California risks running out of cash later this month to pay all of its bills unless its books are balanced quickly.

To conserve cash, State Controller John Chiang plans to issue IOUs by Thursday to the state's vendors, local agencies overseeing health programs and various recipients of state aid -- including the elderly and disabled and college students.

He plans to send $3.36 billion in IOUs this month to help maintain $10.9 billion in other payments, including money owed to investors holding California's general obligation debt.

The general obligation bonds will be paid, Chiang told Reuters on Tuesday. California has never defaulted on its debt obligation and we don't plan to do so.

California aims to reassure investors because Wall Street's concerns about the state's finances are growing and because state officials see the need to sell $7 billion to $9 billion in short-term debt for cash-flow purposes once there is a budget agreement.

Fitch Ratings last week downgraded its rating on California's general obligation debt and warned it may lower the rating again. Fitch cut California's rating by one notch to A-minus, placing it four notches above speculative, or junk status, and making it the lowest rating of any U.S. state.

Standard & Poor's Ratings Services and Moody's Investors Service have also warned of possible downgrades to California's general obligation debt. Moody's has said the state could see a multi-notch downgrade of its A2 rating. S&P rates $57 billion of the state's outstanding general obligation bonds A.

(Additional reporting by Marianne Russ in Sacramento, California; Editing by Eric Walsh)

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