Recession in Indian Aviation - What Caused It

What Caused The Recession

Airlines in India have gone through five phases of development. The first phase was the pioneering years, which started in the pre-independence period and lasted till the early years of post independence era. The second phase started sometimes in the late fifties and continued till the early nineties of the last century. The third phase has been the shortest phase so far that started with the repeal of the Air Corporation Act and ended in 2003. The current phase started with the emergence of low cost airlines and is now in the midst of a recession.

The First Phase – the Pioneering Years

The journey of civil aviation in India began in December 1912. It coincided with the opening of the first domestic air route between Karachi and Delhi by the Indian state Air services in collaboration with the imperial Airways, UK, though it was a mere extension of London-Karachi flight of the latter airline. However, before this the first commercial flight in India was made on February 18, 1911, when a French pilot Monseigneur Piguet flew airmails from Allahabad to Naini, covering a distance of about 10 km in as many minutes.

On October 15, 1932, a light single-engine Puss Moth took off from Karachi on its flight to Mumbai (then known as Bombay) via Ahmedabad. At the controls of the tiny plane was Mr. J.R.D. Tata, operating the first scheduled air service in the country. He landed with his precious load of mail on a grass strip at Juhu. Life was simple then. There were no runways, no radio facilities in the aircraft or on the ground. There were no pretty hostesses, no aerodrome officers and no airport buildings. At Mumbai, Mr Nevill Vintcent took over from Mr. Tata and flew the Puss Moth to Chennai (then known as Madras) via Bellary. Thus was born Tata Airlines, which later became Air India. In 1933, the first full year of its operations, Tata Airlines flew 160,000 miles, carried 155 passengers and 10.71 tonnes of mail.

The Second Phase – Public Sector Era

At the time of independence, the number of air transport companies, which were operating within and beyond the frontiers of the country, carrying both air cargo and passengers, was nine. It was reduced to eight, with Orient Airways shifting to Pakistan.

In early 1948, a joint sector company, Air India International Ltd., was established by the Government of India and Air India (earlier Tata Airline) with a capital of Rs 2 crore and a fleet of three Lockheed constellation aircraft. Its first flight took off on June 8, 1948 on the Mumbai (Bombay)-London air route. At the time of its nationalization in 1953, it was operating four weekly services between Mumbai-London and two weekly services between Mumbai and Nairobi. J.R.D.Tata headed the joint venture.

The soaring prices of aviation fuel, mounting salary bills and disproportionately large fleets took a heavy toll of the then airlines. The financial health of companies declined despite liberal Government patronage, particularly from 1949, and an upward trend in air cargo and passenger traffic. The trend, however, was not in keeping with the expectations of these airlines that had gone on an expansion spree during the post-World War II period, acquiring aircraft and spares.

The Government set up the Air Traffic Enquiry Committee in 1950 to look into the problems of the airline. Though the Committee found no justification for nationalization of airlines, it favoured their voluntary merger. Such a merger, however, was not welcomed by the airlines and the Government had to ultimately nationalize the sector in 1953 and accordingly, two autonomous corporations were created on August 1, 1953. Indian Airlines was formed with the merger of eight domestic airlines to operate domestic services, while Air India International was to operate the overseas services (the word 'International' was dropped in 1962. Effective March 1, 1994, the airline was renamed Air India Limited). At the time of nationalization, Indian Airlines inherited a fleet of 99 aircraft consisting of various types of aircraft.

The third Phase – the Liberalisation Era

Until a decade ago, all aspects of aviation were firmly controlled by the Government. In the early fifties, all airlines operating in the country were merged into either Indian Airlines or Air India and, by virtue of the Air Corporations Act, 1953; this monopoly was perpetuated for the next forty years. The Directorate General of Civil Aviation controlled every aspect of flying including granting flying licenses, pilots, certifying aircrafts for flight and issuing all rules and procedures governing Indian airports and airspace. Finally, the Airports Authority of India was entrusted with the responsibility of managing all national and international airports and administering every aspect of air transport operation through the Air Traffic Control. While nationalization of air transport sector solved quite a few problems during the course of time it also created a few problems. The usual ills associated with monopoly, like rising operating cost due to low productivity, falling standard of service and quality of infrastructure, disregard for passenger amenities, etc.; started to surface. With the general opening up of the economy theses characteristics of civil aviation was rendering the sector out of sync with the rest of the economy and therefore finally the Air Corporation Act was repealed to end the monopoly of the public sector and private airlines were reintroduced.

As was to be expected, liberalisation of air services led to launching of several private sector airlines. East West, Damania Airways, Air Sahara, NEPC Airways, Jet Airways, ModiLuft were some of the prominent airlines set up during that period. Of these, only Jet Airways survives today. The airlines that started operating showed lots of promise in the beginning and many at that time thought that Indian aviation was well on the way to gain maturity. Almost every area of airline business showed improvement. Capacity increased manifold, in 1996 the airlines collectively offered 70,000 seats, there were visible improvement in efficiency in the matter of ground handling, cabin crew, punctuality and on board catering.⁶ It is unfortunate though that what started with so much fan fare soon began to flounder. Within a few years of their operation most of the airlines either closed down or, as it happened in the case of Damania, merged with other airline.

Not much material or analysis is available on the probable cause(s) of the failure of the airlines in establishing themselves as viable operators. However, based on our own analysis we would like to put forward the following:

The pace at which the industry developed was too fast for the national economy to handle. The economy was still growing at 5-6 percent per annum and personal disposable income for a large majority of middle class (i.e.; the potential ‘flying’ class) had not reached the critical mass at which point one could look beyond the daily grind and seek for some luxury. The industry either did not understand or preferred to ignore the income elasticity of demand of its client base and ended up with an incomplete profile of the market.

The industry created capacity that was far in excess of actual demand. In 1996 when air traffic stood at around 27,000 to 32,000 passengers per day, the airlines together offered around 70,000 seats. It would, however, be wrong to blame the airlines for the excess capacity. Since aircrafts come in standard sizes it is in the nature of the airline industry to perpetually operate in environment of demand-supply mismatch. It is one of the inflexibilities that we have already discussed while talking about special characteristics of airline business. It is one of the ironies of airline business that the airlines’ have to bear the consequences of actions of which they are not responsible; in this case the outcome associated with over capacity.

The private sector airline underestimated the strength of the public sector airline. The unspoken belief among the private airlines was that in the onslaught of competition the public sector would soon wither away. That the public sector could (and would) adapt itself to the dictates market demands and improve its efficiency to the extent of successfully retaining a major part of its client base was way beyond the expectations of private airlines, thus the easy pickings of passengers that they were hoping for never materialised.

All the airlines, including the ones that survived, failed to demonstrate entrepreneurial courage and a boldness to experiment with a new idea. The concept of low cost carriers (which in theory at least, is most suited for a country like India) that was taking off at the same period in the West was completely ignored by all the airlines.

The country was not ready for an aviation makeover. Running an airline does not only involve buying an aircraft and flying it also needs the presence of supporting industry aviation finance, for example. The airlines were operating in a void.

Most of the airlines were under capitalised. We have earlier spoken about easy entry as on of the unique characteristics of airline business. In Indian context entry in those were even easier than they are now. Anybody could set up an airline with just one aircraft provided he promised to upgrade to three aircrafts within three years and invested a minimum of rupees one crore. As soon as Air Corporation Act was repealed all the Air Taxi Operators of the time converted themselves into airline companies without any adequate homework. Business economics was the last thing on their mind, if it was there at all. Though airlines like Damania, East West had experienced men running the company yet nothing in the way they ran their airline indicated they were seriously aware how capital intensive the business was. Jet Airways was the only airline to start operation with adequate preparation, it had equity tie up with Gulf Air and Kuwait Airways. It is perhaps because of this tie up and their professionalism that we see Jet’s aircraft in the skies today. The other airline that survived was Air Sahara, which could be ascribed to deep pockets and also the fact that they had not spread their resources too thin.

For all the defunct airlines finance remained the single biggest problem throughout their existence and which ultimately led to their downfall. While Damania sold out to NEPC Airways, NEPC’s own finance kept going from bad to worse to the extent that they kept defaulting on paying taxes and the government had to ultimately confiscate it licences. East West’s died along with the violent death of its MD. ModiLuft’s partnership had to end when Lufthansa called off the deal presumably due to non receipt of dues.

The Fourth Phase – The Era of Growth and . . .

2003 is a watershed year for Indian aviation industry for two significant reasons. First, with re-launch of new private sector airline it finally signalled the end of the shock that followed from the failure of airlines in the earlier phase. Secondly, India entered the era of low cost airlines. Launch of low cost airline (LCA) radically altered the nature of competition within the airline industry, especially on short-haul routes. LCAs exploited different operational methods, fewer service offerings (e.g. charges for in-flight catering) and distribution efficiencies (e.g. internet-only bookings) to lower their cost base and to lower the average fares paid by customers. Strong competition from LCAs forced the full cost airlines (FCAs) to respond or to fail.

India's first low-cost airline, Air Deccan started service on August 25, 2003. The airline's fares for the Delhi-Bangalore route were 30% less than those offered by its rivals such as Indian Airlines, Air Sahara and Jet Airways on the same route. The success of Air Deccan spurred the entry of nearly a dozen low-cost airlines in India. Within a few years setting up its operation Air Deccan had to face stiff competition from other low-cost Indian carriers such as Jetlite, SpiceJet, GoAir, IndiGo Airlines and Paramount Airways. After a year of operation, in 2006, Kingfisher Airlines changed its business model from low-cost to value airlines.

The LCAs made the years 2005 and 2006 the most eventful years for Indian aviation. The two years were characterised by a rapid growth in the size of the passenger market and a fiercely fought price war in which the full service carriers too joined in. Fares kept plunging beyond anybody’s expectation and as fare fell the number of air travellers increased manifold, a significant majority of which were first time travellers. Growth in passengers induced a growth in number of aircrafts as well. There were several other factors as well that contributed to the spurt in growth of the aviation sector. On the demand side were factors like GDP growth, under penetrated market, rising disposable income, growth in tourism. On the supply side were factors like improved infrastructure and a more mature market.

Unlike the past, present day Indian aviation is clearly got divided into two categories that of full service carriers and low cost carriers. The advent of low cost carriers resulted in making significant changes in the nature and development of the industry. As price competition strengthened the pressure on airlines to contain cost increased and as a result quality of service suffered, most noticeable in delays/cancellation of flights and poor in flight catering.

It also had a few downside, the revenue model of LCAs was based on a heavily discounted fare structure and an absolutely stripped down passenger amenities. While the business model of low cost was bringing in the passenger it also meant that margin had to necessarily remain small, significantly this implied that even if an airline was to earn a profit the volume of profit was likely to be low unless the volume of passenger carried was very large. However, increasing the number of passengers might have required increasing the number of destinations, number of aircrafts and so on, which would have implied added overheads and added costs. Thus the success of LCA depended much on the skill of the airline in successfully managing its yield, optimising its route planning and efficient designing of its scheduling.

….. Recession

Fare Setting, Fare War and their Consequences

Though low fares resulted in higher traffic it also led to lower yield, which combined with higher input cost put severe strain on airlines finances. Most of the newly launched airlines were running in losses, even the more established airlines were finding it hard to make profit regularly. Towards the end of 2006, mounting price war, financial losses and rapidly expanding capacity created a situation where an imminent catastrophe of closure of several airlines looked real enough.

If Indian aviation in 2007 has to be described in a single word then ‘consolidation’ would be the right term to use. After a fiercely fought price war in 2006, that saw several airlines coming dangerously close to bankruptcy and thus raising the spectre of a repeat of the 1990s, 2007 saw saner elements prevail. Airlines realized that the price war that they were waging could only result in pyrrhic victory. The most significant gain of 2007 thus was return to realistic pricing of airfare. 2007 witnessed completion of one major merger, setting in motion of the process of merger in another case and in a third case conclusion of a merger the process for which had started in earlier years. Analysts expected that the impact of these consolidations would be felt in 2008; while in the case of Air India-Indian Airlines merger infusion of new funds was not expected, in the case of Deccan-Kingfisher merger a significant infusion of funds was thought to be inevitable in the light of the poor financial health of Air Deccan.

Passenger traffic continued to grow at a healthy rate in 2007. This prompted nearly all the airlines to place orders for buying new aircraft, undeterred by the fact that they posted combined losses of about Rs 2,000 crore largely on account of rising fuel costs.

While yields slid, operation costs mounted. Airline CFOs were reported to claim that more than 80 percent of the cost had become "uncontrollable". These included wage and fuel costs (60 percent of all expenses) and higher depreciation and interest charges. These were taking a toll on the financial health of all airlines.

The sub prime crisis in the US had its impact on the Indian aviation as well. Augmenting funding from international banks became difficult as most major lenders were grappling with the sub prime crisis gripping the US market; they reduced their exposure towards funding airlines.

From the brief description of developments between 2005 and 2007 in the Indian aviation, it can be observed that the genesis of a recession had been shown way back in 2005 and continued in the subsequent year in the form of price war. The industry in general was selling a severely under priced product. Airlines, including full service carriers, were following similar business strategies. The primary aim of airlines at the time was to gain market share. In order to fulfil their objective of obtaining market share the airlines went about offering discounted fare, at times, at ridiculously low rate. For example, as recently as in late 2007 in order to gain market share GoAir positioned its fares around 30 per cent lower than most airlines and on a clogged sector like Mumbai-Delhi, where a Kingfisher ticket cost Rs 2,000 as basic fare a GoAir ticket went as low as Rs 500.

The airlines seemed to believe that if they could garner a fair share of the market then profit would automatically follow. This was obviously based on an inadequate understanding of basic economics. In a competitive market an enterprise can become a price setter if and only if it establishes a dominant position (thumb rule - a market share of over 50%), failing that the enterprise has to remain a price taker. It was over optimistic for any airline to hope to reach the dominant position in the short run in a market that had nearly a dozen competitors. In the long run, through a process of mergers and acquisitions as also demise of a few enterprises, the market may reach a position of oligopoly providing the survivors the power to dictate price and perhaps recoup the earlier losses. The problem is the market never guarantees how long the process would take and who would be the survivors.

In the previous section on economics of airline business we discussed at length the intricacies of rate setting in airline business. It was pointed out rate fixing a combination of cost of service and the value of service. Cost of service is defined as the amount of money needed for a utility to operate and maintain facilities, cover capital expenses, and provide an opportunity to earn a profit. It is obvious that airlines that were deliberately under cutting fares were not aiming at covering even the cost of service, thus an element of loss was inbuilt in their business strategy. Primarily the issue boiled down to the length of time a airline was willing and financially capable of waiting to ultimately acquire the status of a monopolist or a oligopolist. Clearly, alongside price war the airlines were also involved in a battle of attrition, each waiting for the other to blink first.

As for value of service, since under pricing was the order of the day apparently no airline was interested in realising the fare that the traffic was willing to bear. This disinterest of airlines to charge a fair fare had disastrous consequences as demonstrated in the experience of Air Deccan. In a bid to attract passengers Deccan often launched, and much fanfare, schemes like one rupee, three-rupee fare. The airline in its publicity materials never made it clear that it was not offering all its seats at Re. 1 and the numbers of seats under the scheme were very limited. That the whole purpose of the scheme was to attract eyeballs was also never clearly conceded by the airline. Anecdotal evidence suggests that the schemes were successful fulfilling its primary objective of creating a buzz. It was said that usually on the opening day of the scheme would be passengers were logging onto the airline website at the stroke of midnight to grab a ticket. The unfortunate part was that every the schemes were on offer those not getting a ticket far outnumbered those who got one. The disappointments led to negative publicity for the airline as the people were, perhaps without much justification, quick to conclude that the airline was not offering any seat at the promised fare and making a fool of them. Sensing the loss in trust and its negative impact the airline ultimately had to offer many more seats than it originally planned so that there would be a visible number of haves than have nots.

While other airlines did not replicate Deccan’s one rupee scheme they tried counteracting Deccan’s advantage by offering ultra cheap fares. This strategy too had unwelcome consequences. It resulted in airlines getting stuck in ‘sticky price point syndrome’⁷. The syndrome refers to that price of a product which even if marginally breached leads to a severe fall in demand. For some reason, which economists are yet not able to explain properly, the consumer develops a preference for a particular price point of a product. At this price point she is always willing to buy the product, however, the moment the price goes beyond the preferred price point (even by a small degree) she stops her purchase. The funniest thing is that the consumer may still continue to buy the same product but differently positioned by the company. Companies whose products get afflicted by this syndrome find themselves in a peculiar situation. It is not that there is no demand for the product; it is just that at a price beyond the preferred price point the demand dries up. The dilemma faced by the company is whether to retain the price point or abandon it. In the case of airline the passengers got so used to ultra cheap fares that beyond a certain point the efforts of airlines to raise fares often led to passenger deserting air travel and switching back to train travel. Observed data suggests that the preferred price point happens to be Rs. 1000 i.e.; the moment the difference between air and train fare goes beyond this point the reverse movement from air to train starts.

Thus, due to an inadequate understanding of economics of airline business, from 2005 onwards airlines had been a perusing a fare strategy that was tailor made for paving the way towards financial disaster. The airlines made too literal an interpretation of demand theory according to which when price falls demand goes up; yes it does but provided a host of other factors also stand up. In this case the two most important factors that the airlines missed out were price elasticity and income elasticity. In 2007 when airlines started the exercise of fare correction through levy of fuel surcharge, initially the growth in passenger traffic did not suffer. After a point continuous rise in airfares started to become a barrier for low-cost fliers. As fuel surcharges crossed the actual fares in several sectors, several leisure travellers and relatively new flyers started shifting to the railways and long distance buses. Airlines aught to not have ignored them, as this was the segment that had fuelled rapid growth in the sector and which had prompted airlines to add capacity.

Over Capacity

As in 1990s this time too there were far more seats on offer than actual demand. For example, while the passenger traffic in 2006 increased at around 25%, the past year saw a capacity addition of 48%. As on the previous occasion the airlines were not altogether to be blamed for this. Periodic over capacity is a characteristic in an industry where capacity can only be created in manufacturer-determined sizes. Airline shares this characteristic with other modes of transport, notably shipping. An element of cyclic behaviour is, in inbuilt in airline business.

In matured markets commercial aviation business cycles have a period of 7-10 years. In this type of cycles, economic growth as a driver of demand, the ordering and retirement of equipment, and the entry and exit of firms in the different markets are the key variables that influence the length and severity of the cycle.

In the period following the second round of liberalisation effect the following dynamics could be seen as driving the industry. The first effect was advent of a number of new airlines. These new entrants had lower operating costs than incumbent airlines as they operated younger fleets and their employees had low seniority and commensurate salaries. What they lacked was network size – a key parameter for attracting passengers. Therefore, a race began to gain market share and utilise capacity at a disregard for short profitability. This behaviour, although rational in the short-term for a single player, created the illusion that even more capacity is needed as the lowered prices boosted demand; this was exacerbated by a growing economy. Airframe manufacturers and, later, leasing firms were happy to oblige in providing the capacity that was being ordered, despite the mismatch between demand growth and the much higher capacity growth, as that also helped them reduce their unit costs faster and compete for market share in an oligopolistic market.

Overcapacity inevitably led to price wars and substantial losses and even when carriers failed, their aircraft was re-circulated as leased or sold to new entrants willing to try their chances. Investors willing to finance these ventures facilitated this effect.

Two other factors dictated the retention of capacity by airlines: high midterm fixed costs and the sophisticated pricing capability offered by revenue management systems to maximise flight passenger revenue. The significant medium-term fixed costs faced by airlines included the need to “hoard” or retain highly trained employees if the airline was to remain competitive at the next market upturn while the costs for long-term leases, owned equipment and gate leases were also fixed in the medium-term. The high fixed costs made the prospect of price wars more palatable to airline managers as at least these would ensure a source of badly needed short-term liquidity even at the expense of profitability and long-term viability. The modern revenue management software also provide a way of filling up the aircraft at ever higher load factors but at prices that sometimes did not cover the costs of the operation; the belief that the marginal cost of a seat is zero obscured the fact that in some cases the prices charged meant that the break-even load factor exceeded one.

In the description above, the key factor is the repeated mismatch between available capacity and demand in the industry with tight capacity matched by increased demand and high returns and vice versa. Airlines have flexibility in reducing available capacity; depending on the time horizon of the decision maker, schedules can be cut back in the short term and aircraft can be parked, returned to the lessor, sold, or scrapped in the medium and long term while airlines can go out of business. Yet, this flexibility is limited by several factors: firstly, an airline’s frequency and network coverage is a key competitive advantage which is only reluctantly forfeited; secondly, aircraft are expensive assets that do not produce if underutilised while their lease or interest and capital payments continue; thirdly, even when an aircraft is returned to the lessor or sold it will return in the market sooner rather than later.

Conclusion

Rising fuel cost has generally been called responsible for the current recession in the aviation sector. Our analysis, however, point to other factors that were directly responsible than fuel cost. The airline industry had been following a business strategy that bound to lead to recession at some point of time. Though in recent times airlines tried to ward off the inevitable by abandoning price war and attempting to restore a more viable fare structure but their earlier deed had reduced fares to such a low level that bringing that up to a realistic level involved raising fares manifold which the airline were unable to do due to elastic demand that triggered off consumer resistance beyond a certain level of fare. Any steep increase in fare was going to affect passenger demand seriously was likely to jeopardise the financial position of the airlines even further. In nutshell, by following policies that were counter productive to profitable growth airlines had pushed themselves so far into a corner a calamity was waiting to happen; rising fuel only acted as a trigger.