The Ottoman Debt Crisis

When sovereign debt markets globally became more integrated in the 19th century, weaker debtors found a new way to finance deficits, borrowing from abroad. No longer would expedients to budget shortfalls, prudent or not, need to be found domestically. The advances of the 19th century enabled new borrowers to issue bonds to yield-hungry investors in more mature markets. Unfortunately, many of these borrowers ran into trouble and the century saw waves of sovereign debt crises. One of these afflicted the ailing Ottoman Empire. The restructuring there saw certain government revenues put in the hands of creditors through an intermediary institution separate from the Ottoman government, the Ottoman Public Debt Administration.

Integration

In the mid-19th century, the territory of the Ottoman Empire diminished with the loss of territories including Greece, Serbia, and Egypt. Obviously in decline, the country was identified as the ‘sick man of Europe’. However, the century was marked by increased integration with Europe’s economy. Exports of agricultural products grew and this trade encouraged the development of a banking system, based around the Galata area of Constantinople. The Ottoman Empire also gained access to European capital markets and began to borrow abroad in the middle of the century.

A persistent aspect of Ottoman integration with Europe was its borrowing in European financial markets. True, the Ottoman state did borrow locally from its newly developed banking system, but several factors also drove external borrowing. One of these was the increase in the supply of capital in large European economies looking for investment opportunities that yielded more than the bonds sold by more creditworthy governments. In the 19th century, investors in Britain and France were increasingly willing to take risks in search of higher returns abroad.

Meanwhile, the Ottoman Empire was in need of deficit financing. The country’s government regularly incurred budget deficits and had financed these in the past by periodic debasements of the coinage. However, it was increasingly looking for alternatives to this disfavored approach. It could borrow domestically of course but the rates at which it could borrow abroad were lower than those offered by domestic lenders. As a result, both supply and demand for credit were working to link the Ottoman state with European investor capital in the mid-19th century.

Foreign Borrowing

Ottoman borrowing abroad began in 1854 with a £3 million loan guaranteed by Britain. Despite this support, the 6% coupon bonds were issued at a price of just 80% of face value. The reason for the British guarantee was the alliance between Britain and the Ottoman Empire during the Crimean War. The proceeds were used to finance military spending during the war which the Ottomans ultimately won but from which it gained little. Indeed, hardly any of the Ottoman borrowing went to financing investment or other projects that increase capacity to repay and military spending was the usual destination of funds.

One bank in particular played a large role in connecting the Ottoman state with investors abroad, the Imperial Ottoman Bank, founded in 1856 with a capital of £500,000. The Imperial Ottoman Bank was a British bank acting as an underwriter of Ottoman bonds in Europe.

The British investors were later joined by a French group that took a 50% stake; over time, the ownership of the bank became even more French. In any case, the bank sold Ottoman state bonds in both the London and Paris markets. Thereafter, it made a 1% commission for handling payments on the external debt. The Imperial Ottoman Bank went on to act as a sort of central bank of the Ottoman Empire, despite being a foreign-owned firm. Nonetheless, the bank’s day-to-day operations were in fact run out of Constantinople.

Both the 1854 loan guaranteed by Britain and future issuances of Ottoman state bonds were secured by particular revenues, either in the form of taxes, tithes, or tributes. Loans were raised abroad secured by customs revenue, tithes received from tobacco and salt monopolies, taxes on flocks of sheep, and the revenues of specific provinces.

During this period, the Ottoman tax system was rather inefficient, relying on land taxes that were difficult and expensive to collect relative to customs duties and other taxes. To collect agricultural taxes from payers distributed across the Empire, the government relied on a network of tax farmers who knew their local economies best. Regardless, the iltizam system, as it was known, was expensive to maintain. An unsuccessful attempt to modernize the tax system away from tax farmers was made during the Tanzimat reforms of 1839 but this was subsequently reversed.

The Crimean War ended in 1856, but peace did not stop the borrowing. After support from the British and French governments ended, borrowing costs on new bonds rose. By 1860, the Ottoman government was having trouble borrowing and new 6% coupon bonds were sold for just 63% of face value for an actual yield to investors of closer to 9.5%. After considering fees paid to bankers selling the bonds, the government collected even less from the offerings, bringing the all-in cost for later bond issues to around 12%.

It may seem as though the Ottoman government was firmly on an unsustainable path with its expensive borrowing. Nonetheless, a report on the public finances written by two British observers was optimistic enough to reassure investors. The report tallied the government’s outstanding debt and published a figure of £36.5 million. Through the 1860s and 1870s, the Ottoman state continued to borrow but was still forced to do so on unfavorable terms. The state also increased domestic taxes to fund expenses, curtailing the borrowing requirement somewhat.

Bankruptcy

In the 1870s, drought and floods damaged agrarians and a financial crisis abroad made financing the public debt difficult. High interest rates were also making the cost of servicing the debt unbearably high. In the face of deteriorating fiscal and market conditions, the government partially missed interest payments in 1875 and suspended all debt payments the following year. By this point, the Ottoman state was almost £200 million in debt.

Following the bankruptcy, the Ottoman debt was cut in nearly half, slashed down to £96 million. Providing further relief, most unpaid interest was canceled. However, the fiscal crisis could not have come at a worse time, on the eve of another war with Russia that ended in 1878 with Turkish defeat. The Russians sought to secure an indemnity from the defeated, and bankrupt, Ottoman state so the peace treaty could not ignore Ottoman debts. The newly independent Balkan states agreed to take on their share of central government debt and the Russians subordinated their indemnity payments to pre-war Ottoman debt repayments.

Ottoman Public Debt Administration

Among the other results of the Ottoman bankruptcy of 1876 was the establishment of the Ottoman Public Debt Administration (OPDA) in 1881. The OPDA was created out of an agreement between the Ottoman government and the governments of foreign creditors. Its objective was to use the tax revenues pledged as collateral for the bonds to provide some recovery to bondholders.

The OPDA went on to control 20% of Ottoman tax revenues which it redirected to creditors; it was given control of revenues ranging from monopolies on tobacco and salt to taxes on spirits, fishing, and silk. However, having learned from an earlier debt restructuring in Egypt, where resentment of foreign creditors grew, the OPDA continued to rely on local tax collectors.

The creation of the OPDA was part of a larger settlement with creditors. The latter also insisted on a faithful return to the gold standard, which the government partially implemented, replacing an earlier bimetallist standard based on gold and silver. The Ottoman state did not have the financial resources to redeem its stock of silver money but did reduce the supply of silver coins. The government continued to follow the prescriptions of the OPDA even during national crises. In the decades after its default, the country went on to fight five wars and experienced three revolutions.

Mutual Benefits

While the potential for controversy surrounding the OPDA is obvious, the Ottoman government generally supported it. It perhaps helped matters that the regime was relatively autocratic and thus able to enact fiscal reforms with fewer direct political consequences. That said, the debt restructuring and the establishment of the OPDA helped the country continue borrowing and even lowered future borrowing costs. Indeed, almost immediately after its bankruptcy, the cost of public borrowing went down. This outcome permitted the country to finance its continued deficit spending. However, it also allowed the country to postpone further fiscal reforms that might otherwise have been prudent.

Regardless, there were other benefits. The OPDA provided reliable and trustworthy bookkeeping and administrative reforms created a more effective collection of taxes. The organization published annual reports with detailed information about the revenues it controlled, giving creditors greater confidence in the public finances of a country whose numbers they often doubted. The fiscal restructuring also encouraged foreign direct investment, much of it directed to railway development. The OPDA also acted as a check on the power of the sultan in this country without a parliament, further mollifying investors.

It is somewhat remarkable that the ‘sick man of Europe’ was able to borrow as cheaply as ever in its waning years. In the very late 19th and early 20th century, the Ottoman government was able to borrow at rates of 4% to 5%. This was not the result of falling interest rates globally. Indeed, on a relative basis, the premium offered by Ottoman debt over British bonds fell from roughly 8% in the pre-bankruptcy years to under 2%. The borrowing was also put to better use. After the Ottoman bankruptcy of 1876, new debts increasingly went to productive investment, particularly in railways, complementing private investment in that sector. The OPDA remained in place until the First World War, by which point, unfortunately, the government was as indebted as it was in the 1870s.

Lesson

Debt restructuring is never easy and in terms of the scale of the write-down of pre-bankruptcy debts, the Ottoman default of 1876-81 was not a small one. Yet, the outcome for the country was relatively positive. Indeed, within a few years, the Ottoman government was borrowing at rates of interest well below that of its pre-default period. Few borrowers would expect the terms on which they receive credit to improve following a bankruptcy but that was exactly the surprising outcome witnessed in Constantinople and in the financial markets in Europe. The OPDA’s reforms proved to be a worthwhile, if politically delicate, solution.

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