5Recession 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 200 . 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 !ourney of civil aviation in India began in "ecember #$#2. It coincided with the opening of the first domestic air route between %arachi and "elhi by the Indian state Air services in collaboration with the imperial Airways, &%, though it was a mere e'tension of (ondon%arachi flight of the latter airline. )owever, before this the first commercial flight in India was made on *ebruary #+, #$##, when a *rench pilot ,onseigneur -iguet flew airmails from Allahabad to .aini, covering a distance of about #0 /m in as many minutes. 0n 0ctober #1, #$ 2, a light single-engine -uss ,oth too/ off from %arachi on its flight to ,umbai 2then /nown as 3ombay4 via Ahmedabad. At the controls of the tiny plane was ,r. 5.6.". Tata, operating the first scheduled air service in the country. )e landed with his precious load of mail on a grass strip at 5uhu. (ife 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 ,umbai, ,r .evill 7intcent too/ over from ,r. Tata and flew the -uss ,oth to Chennai 2then /nown as ,adras4 via 3ellary. Thus was born Tata Airlines, which later became Air India. In #$ , the first full year of its operations, Tata Airlines flew #80,000 miles, carried #11 passengers and #0.9# 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 0rient Airways shifting to -a/istan. In early #$:+, a !oint sector company, Air India International (td., was established by the ;overnment of India and Air India 2earlier Tata Airline4 with a capital of 6s 2 crore and a fleet of three (oc/heed constellation aircraft. Its first flight too/ off on 5une +, #$:+ on the ,umbai 23ombay4-(ondon air route. At the time of its nationali<ation in #$1 , it was operating four

wee/ly services between ,umbai-(ondon and two wee/ly services between ,umbai and .airobi. 5.6.".Tata headed the !oint venture. The soaring prices of aviation fuel, mounting salary bills and disproportionately large fleets too/ a heavy toll of the then airlines. The financial health of companies declined despite liberal ;overnment patronage, particularly from #$:$, and an upward trend in air cargo and passenger traffic. The trend, however, was not in /eeping with the e'pectations of these airlines that had gone on an e'pansion spree during the post-=orld =ar II period, ac>uiring aircraft and spares. The ;overnment set up the Air Traffic ?n>uiry Committee in #$10 to loo/ into the problems of the airline. Though the Committee found no !ustification for nationali<ation of airlines, it favoured their voluntary merger. @uch a merger, however, was not welcomed by the airlines and the ;overnment had to ultimately nationali<e the sector in #$1 and accordingly, two autonomous corporations were created on August #, #$1 . 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 2the word AInternationalA was dropped in #$82. ?ffective ,arch #, #$$:, the airline was renamed Air India (imited4. At the time of nationali<ation, Indian Airlines inherited a fleet of $$ aircraft consisting of various types of aircraft.
The third Phase the Liberalisation Era

&ntil a decade ago, all aspects of aviation were firmly controlled by the ;overnment. 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, #$1 B this monopoly was perpetuated for the ne't forty years. The "irectorate ;eneral 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. *inally, 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. =hile nationali<ation of air transport sector solved >uite a few problems during the course of time it also created a few problems. The usual ills associated with monopoly, li/e rising operating cost due to low productivity, falling standard of service and >uality of infrastructure, disregard for passenger amenities, etc.B started to surface. =ith 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 e'pected, liberalisation of air services led to launching of several private sector airlines. ?ast =est, "amania Airways, Air @ahara, .?-C Airways, 5et Airways, ,odi(uft were some of the prominent airlines set up during that period. 0f these, only 5et 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 #$$8 the airlines

collectively offered 90,000 seats, there were visible improvement in efficiency in the matter of ground handling, cabin crew, punctuality and on board catering.8 It is unfortunate though that what started with so much fan fare soon began to flounder. =ithin a few years of their operation most of the airlines either closed down or, as it happened in the case of "amania, merged with other airline. .ot much material or analysis is available on the probable cause2s4 of the failure of the airlines in establishing themselves as viable operators. )owever, based on our own analysis we would li/e to put forward the followingC The pace at which the industry developed was too fast for the national economy to handle. The economy was still growing at 1-8 percent per annum and personal disposable income for a large ma!ority of middle class 2i.e.B the potential DflyingE class4 had not reached the critical mass at which point one could loo/ beyond the daily grind and see/ for some lu'ury. 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 mar/et. The industry created capacity that was far in e'cess of actual demand. In #$$8 when air traffic stood at around 29,000 to 2,000 passengers per day, the airlines together offered around 90,000 seats. It would, however, be wrong to blame the airlines for the e'cess capacity. @ince aircrafts come in standard si<es it is in the nature of the airline industry to perpetually operate in environment of demand-supply mismatch. It is one of the infle'ibilities that we have already discussed while tal/ing about special characteristics of airline business. It is one of the ironies of airline business that the airlinesE have to bear the conse>uences of actions of which they are not responsibleB in this case the outcome associated with over capacity. The private sector airline underestimated the strength of the public sector airline. The unspo/en belief among the private airlines was that in the onslaught of competition the public sector would soon wither away. That the public sector could 2and would4 adapt itself to the dictates mar/et demands and improve its efficiency to the e'tent of successfully retaining a ma!or part of its client base was way beyond the e'pectations of private airlines, thus the easy pic/ings 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 e'periment with a new idea. The concept of low cost carriers 2which in theory at least, is most suited for a country li/e India4 that was ta/ing off at the same period in the =est was completely ignored by all the airlines. The country was not ready for an aviation ma/eover. 6unning an airline does not only involve buying an aircraft and flying it also needs the presence of supporting industry aviation finance, for e'ample. The airlines were operating in a void.

,ost of the airlines were under capitalised. =e have earlier spo/en about easy entry as on of the uni>ue characteristics of airline business. In Indian conte't entry in those were even easier than they are now. Anybody could set up an airline with !ust 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 Ta'i 0perators of the time converted themselves into airline companies without any ade>uate homewor/. 3usiness economics was the last thing on their mind, if it was there at all. Though airlines li/e "amania, ?ast =est had e'perienced men running the company yet nothing in the way they ran their airline indicated they were seriously aware how capital intensive the business was. 5et Airways was the only airline to start operation with ade>uate preparation, it had e>uity tie up with ;ulf Air and %uwait Airways. It is perhaps because of this tie up and their professionalism that we see 5etEs aircraft in the s/ies today. The other airline that survived was Air @ahara, which could be ascribed to deep poc/ets and also the fact that they had not spread their resources too thin. *or all the defunct airlines finance remained the single biggest problem throughout their e'istence and which ultimately led to their downfall. =hile "amania sold out to .?-C Airways, .?-CEs own finance /ept going from bad to worse to the e'tent that they /ept defaulting on paying ta'es and the government had to ultimately confiscate it licences. ?ast =estEs died along with the violent death of its ,". ,odi(uftEs partnership had to end when (ufthansa called off the deal presumably due to non receipt of dues.
The Fourth Phase The Era o !ro"th and # # #

200 is a watershed year for Indian aviation industry for two significant reasons. *irst, with relaunch of new private sector airline it finally signalled the end of the shoc/ that followed from the failure of airlines in the earlier phase. @econdly, India entered the era of low cost airlines. (aunch of low cost airline 2(CA4 radically altered the nature of competition within the airline industry, especially on short-haul routes. (CAs e'ploited different operational methods, fewer service offerings 2e.g. charges for in-flight catering4 and distribution efficiencies 2e.g. internetonly boo/ings4 to lower their cost base and to lower the average fares paid by customers. @trong competition from (CAs forced the full cost airlines 2*CAs4 to respond or to fail. IndiaAs first low-cost airline, Air "eccan started service on August 21, 200 . The airlineAs fares for the "elhi-3angalore route were 0F less than those offered by its rivals such as Indian Airlines, Air @ahara and 5et Airways on the same route. The success of Air "eccan spurred the entry of nearly a do<en low-cost airlines in India. =ithin a few years setting up its operation Air "eccan had to face stiff competition from other low-cost Indian carriers such as 5etlite, @pice5et, ;oAir, Indi;o Airlines and -aramount Airways. After a year of operation, in 2008, %ingfisher Airlines changed its business model from low-cost to value airlines. The (CAs made the years 2001 and 2008 the most eventful years for Indian aviation. The two years were characterised by a rapid growth in the si<e of the passenger mar/et and a fiercely

fought price war in which the full service carriers too !oined in. *ares /ept plunging beyond anybodyEs e'pectation and as fare fell the number of air travellers increased manifold, a significant ma!ority of which were first time travellers. ;rowth 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. 0n the demand side were factors li/e ;"- growth, under penetrated mar/et, rising disposable income, growth in tourism. 0n the supply side were factors li/e improved infrastructure and a more mature mar/et. &nli/e 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 ma/ing 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 >uality of service suffered, most noticeable in delaysGcancellation of flights and poor in flight catering. It also had a few downside, the revenue model of (CAs was based on a heavily discounted fare structure and an absolutely stripped down passenger amenities. =hile 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 li/ely to be low unless the volume of passenger carried was very large. )owever, increasing the number of passengers might have re>uired increasing the number of destinations, number of aircrafts and so on, which would have implied added overheads and added costs. Thus the success of (CA depended much on the s/ill 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. ,ost of the newly launched airlines were running in losses, even the more established airlines were finding it hard to ma/e profit regularly. Towards the end of 2008, mounting price war, financial losses and rapidly e'panding capacity created a situation where an imminent catastrophe of closure of several airlines loo/ed real enough. If Indian aviation in 2009 has to be described in a single word then DconsolidationE would be the right term to use. After a fiercely fought price war in 2008, that saw several airlines coming dangerously close to ban/ruptcy and thus raising the spectre of a repeat of the #$$0s, 2009 saw saner elements prevail. Airlines reali<ed that the price war that they were waging could only result in pyrrhic victory. The most significant gain of 2009 thus was return to realistic pricing of airfare. 2009 witnessed completion of one ma!or 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 e'pected that the impact of these consolidations would be felt in

200+B while in the case of Air India-Indian Airlines merger infusion of new funds was not e'pected, in the case of "eccan-%ingfisher merger a significant infusion of funds was thought to be inevitable in the light of the poor financial health of Air "eccan. -assenger traffic continued to grow at a healthy rate in 2009. This prompted nearly all the airlines to place orders for buying new aircraft, undeterred by the fact that they posted combined losses of about 6s 2,000 crore largely on account of rising fuel costs. =hile yields slid, operation costs mounted. Airline C*0s were reported to claim that more than +0 percent of the cost had become HuncontrollableH. These included wage and fuel costs 280 percent of all e'penses4 and higher depreciation and interest charges. These were ta/ing a toll on the financial health of all airlines. The sub prime crisis in the &@ had its impact on the Indian aviation as well. Augmenting funding from international ban/s became difficult as most ma!or lenders were grappling with the sub prime crisis gripping the &@ mar/etB they reduced their e'posure towards funding airlines. *rom the brief description of developments between 2001 and 2009 in the Indian aviation, it can be observed that the genesis of a recession had been shown way bac/ in 2001 and continued in the subse>uent 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 mar/et share. In order to fulfil their ob!ective of obtaining mar/et share the airlines went about offering discounted fare, at times, at ridiculously low rate. *or e'ample, as recently as in late 2009 in order to gain mar/et share ;oAir positioned its fares around 0 per cent lower than most airlines and on a clogged sector li/e ,umbai-"elhi, where a %ingfisher tic/et cost 6s 2,000 as basic fare a ;oAir tic/et went as low as 6s 100. The airlines seemed to believe that if they could garner a fair share of the mar/et then profit would automatically follow. This was obviously based on an inade>uate understanding of basic economics. In a competitive mar/et an enterprise can become a price setter if and only if it establishes a dominant position 2thumb rule - a mar/et share of over 10F4, failing that the enterprise has to remain a price ta/er. It was over optimistic for any airline to hope to reach the dominant position in the short run in a mar/et that had nearly a do<en competitors. In the long run, through a process of mergers and ac>uisitions as also demise of a few enterprises, the mar/et may reach a position of oligopoly providing the survivors the power to dictate price and perhaps recoup the earlier losses. The problem is the mar/et never guarantees how long the process would ta/e 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 fi'ing 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 e'penses, 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. -rimarily the issue boiled down to the length of time a airline was willing and financially capable of waiting to ultimately ac>uire 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 blin/ 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 conse>uences as demonstrated in the e'perience of Air "eccan. In a bid to attract passengers "eccan often launched, and much fanfare, schemes li/e one rupee, three-rupee fare. The airline in its publicity materials never made it clear that it was not offering all its seats at 6e. # 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 ob!ective of creating a bu<<. It was said that usually on the opening day of the scheme would be passengers were logging onto the airline website at the stro/e of midnight to grab a tic/et. The unfortunate part was that every the schemes were on offer those not getting a tic/et far outnumbered those who got one. The disappointments led to negative publicity for the airline as the people were, perhaps without much !ustification, >uic/ to conclude that the airline was not offering any seat at the promised fare and ma/ing a fool of them. @ensing 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. =hile other airlines did not replicate "eccanEs one rupee scheme they tried counteracting "eccanEs advantage by offering ultra cheap fares. This strategy too had unwelcome conse>uences. It resulted in airlines getting stuc/ in Dstic/y price point syndromeE9. The syndrome refers to that price of a product which even if marginally breached leads to a severe fall in demand. *or some reason, which economists are yet not able to e'plain 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 2even by a small degree4 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 productB it is !ust 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 bac/ to train travel. 0bserved data suggests that the preferred price point

happens to be 6s. #000 i.e.B 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 inade>uate understanding of economics of airline business, from 2001 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 upB 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 2009 when airlines started the e'ercise 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 #$$0s this time too there were far more seats on offer than actual demand. *or e'ample, while the passenger traffic in 2008 increased at around 21F, the past year saw a capacity addition of :+F. As on the previous occasion the airlines were not altogether to be blamed for this. -eriodic over capacity is a characteristic in an industry where capacity can only be created in manufacturer-determined si<es. Airline shares this characteristic with other modes of transport, notably shipping. An element of cyclic behaviour is, in inbuilt in airline business. In matured mar/ets commercial aviation business cycles have a period of 9-#0 years. In this type of cycles, economic growth as a driver of demand, the ordering and retirement of e>uipment, and the entry and e'it of firms in the different mar/ets are the /ey 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. =hat they lac/ed was networ/ si<e I a /ey parameter for attracting passengers. Therefore, a race began to gain mar/et 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 demandB this was e'acerbated 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 mar/et share in an oligopolistic mar/et.

0vercapacity 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 airlinesC high midterm fi'ed costs and the sophisticated pricing capability offered by revenue management systems to ma'imise flight passenger revenue. The significant medium-term fi'ed costs faced by airlines included the need to JhoardK or retain highly trained employees if the airline was to remain competitive at the ne't mar/et upturn while the costs for long-term leases, owned e>uipment and gate leases were also fi'ed in the medium-term. The high fi'ed 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 li>uidity even at the e'pense 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 operationB the belief that the marginal cost of a seat is <ero obscured the fact that in some cases the prices charged meant that the brea/-even load factor e'ceeded one. In the description above, the /ey 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 fle'ibility in reducing available capacityB depending on the time hori<on of the decision ma/er, schedules can be cut bac/ in the short term and aircraft can be par/ed, returned to the lessor, sold, or scrapped in the medium and long term while airlines can go out of business. Let, this fle'ibility is limited by several factorsC firstly, an airlineEs fre>uency and networ/ coverage is a /ey competitive advantage which is only reluctantly forfeitedB secondly, aircraft are e'pensive assets that do not produce if underutilised while their lease or interest and capital payments continueB thirdly, even when an aircraft is returned to the lessor or sold it will return in the mar/et sooner rather than later.
Conclusion

6ising fuel cost has generally been called responsible for the current recession in the aviation sector. 0ur 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 li/ely to !eopardise 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 happenB rising fuel only acted as a trigger.