Drowning in Debt, Starving for Cash: The Liquidity Crisis and Circular Debt Catastrophe in Pakistan’s Energy Sector

Abstract

The liquidity crisis in Pakistan’s fuel and energy sector is one of the most pressing financial challenges, driven primarily by circular debt, weak institutional governance, and financial mismanagement. This study investigates the determinants of corporate liquidity in the sector, examining how firm-specific financial characteristics, debt structures, investment behavior, and risk exposure influence liquidity holdings. Using a panel dataset from 2006 to 2024, this research employs Pooled Least Squares (PLS), Fixed Effects Model (FEM), and Random Effects Model (REM) to analyze liquidity trends while applying the Hausman test to determine the best-fitting model. The results indicate that firm size, debt-to-asset ratios, and earnings risk significantly impact liquidity holdings, while circular debt emerges as the most critical constraint on financial stability. The study finds that firms with high leverage and short-term debt exposure hold liquidity buffers as a precautionary measure, aligning with the precautionary liquidity hypothesis. However, circular debt negatively impacts liquidity, restricting firms’ ability to meet operational needs and invest in growth. The Hausman test favors the Random Effects Model (REM), suggesting that macroeconomic and policy-driven factors play a dominant role over firm-specific characteristics in determining liquidity management. The findings underscore the urgent need for regulatory and financial reforms, emphasizing the root causes of circular debt, such as delayed government payments, inefficient subsidy mechanisms, and weak institutional controls. Policy recommendations include establishing an independent energy regulatory authority, enforcing strict budgetary controls over energy subsidies, and introducing an automated payment clearing system to prevent liquidity constraints. The study contributes to academic discourse on liquidity management in emerging economies and provides actionable insights for policymakers and industry leaders to break free from the liquidity trap and restore financial stability in Pakistan’s energy sector.