Circular debt is a unique but not necessarily unheard of problem. Two entities ultimately owe debt to each other but cannot balance out their debt because it is indirectly owed through additional entities. At least three parties must be involved. In the simplest terms, A owes money to B, who owes money to C, who completes the circle by owing money to A.
In a way, circular debt can also be thought of as "debt with a middleman". If A owed money directly to C without B existing in the middle and C owed money to A, the debts would cancel out each other. However, because B (or possibly a chain of middlemen) does indeed exist, the debt gets passed around the circle instead of getting cancelled out. This can lead to frustrating problems.
Circular debt is defined as a chain of creditors and debtors that circles back onto itself, where the final creditor is in debt to the first debtor in the chain.
The phrase "circular debt" first became popular due to an electricity crisis in Pakistan. The entities involved in this example are the government, power distributors, power producers, fuel suppliers and the consumers.
Because the Pakistani government is struggling financially and experiencing a slow economy, it is unable to pay subsidies to power distributors. The power distributors in turn do not have enough money to pay the power producers, who cannot purchase fuel to keep the plants running and therefore fail to provide electricity owed to the consumers, who also often refuse to pay their bills for electricity that doesn't work. In turn, consumers are expected to pay taxes to the government, bringing the debt full circle.
As you can see from this example, there is no easy solution for breaking this circle of debt and restoring electricity to the people of Pakistan. An injection of money needs to occur somewhere in the circle to keep the money moving, but from where will it come?
When the consumers do not have reliable electricity, their businesses often suffer, and therefore they do not have much money to contribute to taxes to help the government pay for the electricity subsidies. Without the subsidies, the electricity distributors would charge much higher tariffs for the electricity, which would also negatively impact the end consumers and their ability to use electricity to earn money to pay their taxes.
Pakistan's circular debt represents a complex problem that cycles on without a clear solution.
Circular debt can have extreme consequences, as the Pakistani example illustrates. However, your small business might also experience circular debt but hopefully in a less-drastic way.
Any time government subsidies are involved at any stage in the process, circular debt is born. For example, say a consumer goes to your store and "owes" (pays) you money for fresh produce. You owe (pay) a farmer for that fresh produce, but the farmer pays taxes to the government to receive subsidies, and the government owes additional services and money to the consumer.
Although real-life examples often become more complex, with smaller circles looping back on the main circle, it's clear that the money gets passed around. It doesn't cause a crisis as long as there's enough money for payments to be made. As soon as it turns into a debt (such as if the consumer's check bounced due to lack of funds), there's a hiccup in the system. You can avoid having to worry about circular debt by making sure you get paid in secure ways (many small businesses do not accept checks for this very reason) and by dealing directly with suppliers whenever possible in order to cut out the middlemen.