Weak pricing power of leading carriers raises doubt on robustness of demand conditions.
Ever since the Central Statistical Office (CSO) published its new GDP series in January 2015, there has been scepticism from different quarters if this reflects realities on the ground. The sudden, sharp acceleration in GDP growth, pumped up by robust consumption stories, failed to convince many critics, including this writer. In the past, we have questioned the claims in support of a sustained economic recovery, citing dismal trends of many leading indicators, such as decelerating credit growth, low capacity utilisation, subdued IIP, export growth, etc. A few of these indicators have begun to show some positive movement in the last two quarters, but it’s still not clear if such trends will sustain given the emerging macroeconomic headwinds!
However, during this entire period, one sector stood out—air traffic growth, which has been consistently growing above 15%, quarter after quarter. Supporters of the recovery story have often flagged this as one of the most convincing lead indicators displaying strong consumption demand, particularly in the urban segment. Many, including this writer, questioned any such claims; it was pointed out that the aviation sector benefitted from sharp reductions in turbine fuel (ATF) costs and passed on the gains to attract prime customers away from railways, whose annual growth slowed in equal measure (see graphic).
With the first burst of reversals in ATF prices, the sector is suddenly confronted with reality. With the rupee turning weaker by the day, the situation has turned into a classic case of testing the robustness of demand conditions faced by this sector. If indeed demand is robust, as captured in its sustained growth in passenger volumes, the industry should be able to protect its margins by passing on the higher costs to customers. But, this is easier said than done.
Faced with intense competition, excess capacity and the presence of fiscally-supported, government-owned Air India, private carriers have found it difficult to raise airfares. But, in the background lies a much larger concern—losing out to the railways if demand turned out be mere substitution!
It is in this backdrop that recent press reports regarding potential bank defaults by Jet Airways and the dismal quarterly results of two more leading private carriers, Indigo and SpiceJet, need to be seen, instead of burying them as individual company-related problems. Profits for the last two airlines have plunged in the first quarter of this financial year, while the Jet Airways’ management publicly admitted that it was looking for fresh capital infusion. All of them, on record, mentioned two common factors pulling down performances—a rise in fuel costs and rupee depreciation. Combined, the two pushed up input costs, squeezed margins and drove profits down or into losses.
Clearly, none of the three was in a position to raise prices or airfares and pass on the raised costs to consumers, that are fliers in this case. If the airlines are being compelled to absorb higher costs, thereby eroding margins and profits, what inference can we make about demand?
Jet Airways, India’s second largest airline, had already tipped into losses (Rs 10.4 billion) in the March-2018 quarter as cost per passenger km rose. Its June quarter results are still awaited with its controversial deferment triggering speculation and concern, including if the airline’s account had turned bad with banks that have also reported to have refused further credit. Jet management attributes the poor performance to the spike in oil prices and a weaker rupee this year. That is an indication that these factors were the primary driver of its profits in FY17, earned by attracting more passengers on the strength of low airfares.
The top low-cost airline, IndiGo, the market leader, also reported its lowest quarterly profit in three years. Earnings, said its management, were eroded by surging fuel costs and forex losses, additional contributors being lower fares and higher maintenance costs of older aircrafts. Here too, oil prices and the depreciated rupee are the tipping factors. Next, SpiceJet too posted a Rs 381 million loss in the June quarter. Yet again on account of higher fuel costs (52% y-o-y), forex losses (Rs 510 million) and arbitration awards, despite revenues having increased 19.6%. Oil prices and rupee depreciation are the key culprits.
Intense competition and aggressive pricing have driven the passenger growth of each of these airlines. The fact that none is able to increase airfares suggests demand is not strong enough to absorb or sustain an increase in airfares. All, therefore, have taken a hit upon margins and profits. That this downturn is synchronised with the oil price upturn and a depreciated rupee is telling—the strong, double-digit growth of aviation passenger traffic in the three preceding years came on the back of exceptionally low input costs and a favourable exchange rate, both of which allowed the airlines to draw passengers from railways. Rail-air travel differentials narrowed so much, allowing passengers to migrate towards faster travel options by paying a tad more. As the chart shows, air passenger traffic growth seems to have come at the cost of railways where passenger traffic contracted in FY16, the peak year in terms of trade gains, and has barely grown one percent subsequently. A lot of the air travel demand, then, was substitution demand as travellers shifted from rail to air. It wasn’t genuine demand.
The situation now is probably such that if these airlines increase airfares, they may lose many passengers who will likely substitute travel in the reverse direction as a result. The aviation industry does not have any pricing power because it cannot retain such passenger volumes by increasing prices. Pricing power exists when demand is genuine, i.e. not substituting one travel mode for another, or if it is so strong that any increase in input prices can be passed on.
But, we all consider trends in aviation passenger traffic growth as one of the leading economic indicators informing us about demand conditions. Airlines’ performance now confirms their fast growth—fastest in the world—didn’t just ride on low costs and airfares, but also upon substitution demand that could be kept up due to oil prices remaining as low as they were and a strong rupee that appreciated some 20% in three years.
Air traffic growth, under these circumstances, is more a misleading indicator than a leading one. As Air India awaits a bailout after failing to attract any bidder, the aviation industry situation is ripening for another private carrier going under, after Kingfisher. That apart, the bigger worry is that mistaking this demand as ‘genuine’ and not recognising it correctly as ‘substitution’ also elicited a regional connectivity scheme by the government—Ude Desh Ka Aam Nagrik, or UDAN—launched last year. The market segment UDAN seeks to serve is probably even closer to its competitor, the railways. In which case, because imported fuel costs and rupee depreciation hit all importers and oil consumers, these investments also risk going bad even as they come onstream. Should not the government relook its taxation of ATF to provide some relief!
The author is New Delhi based macroeconomist