India is driving expansion in South Asia

Nothing is ever wholly predictable in India's market, but the country does seem to have turned a corner. While domestic growth has surged, the addition of one more of India's LCCs to international routes in 2017 will help promote the country's international profile. As this rapid aviation growth occurs however, the inadequacy of India's infrastructure is building to become a major stumbling block.

India's domestic market is set to surpass 100 million passengers this financial year. In the 12 months to 31-Mar-2017, India is likely to overtake Japan to become the third largest domestic market behind the USA and China.

In reaching this milestone, India will have achieved average domestic traffic growth of over 15% per annum since the liberalisation of the sector commenced in FY2004. Traffic growth has been particularly strong over the past two years, up 21.4% in FY2016 and on track to achieve slightly faster growth in the current year.

India Domestic Airline Passengers FY2004-2017F

Source: CAPA - centre for aviation & Airports Authority of India

Strong economic fundamentals have contributed to the growth - although traffic has been over-stimulated by low fares. India is expected to achieve 7.5% GDP growth in FY2017, with the IMF projecting that economic performance should improve still further over the next five years.

However, the impact of the Indian government's demonetisation initiative announced in Nov-2016 (which resulted in the withdrawal and replacement of around 86% of the value of currency in circulation, to reduce the volume of undeclared cash in the economy) is still unclear.

Projected delivery dates of aircraft to Indian carriers as at 21-Dec-2016

Source: CAPA Fleet Database

With Indian carriers scheduled to take delivery of 50-60 aircraft in FY2018, most of which will be deployed on domestic routes, growth could approach 25% in 2017 (although demonetisation may reduce this by 3-5 ppts).

As a result, the market is likely to post three consecutive years of domestic growth above 20% p/a. Based on aircraft deliveries, competitive dynamics and the outlook for economic growth, this could continue for up to a further two years.

IndiGo is increasingly controlling domestic capacity and growth. Its share of traffic could approach 55%-60% within the next two years, a remarkable achievement in such a large and competitive market. IndiGo will take delivery of more than two aircraft a month through to Mar-2018 which will see its fleet size reach 160 by then.

India Domestic Airline Market Shares Nov-2016

Source: CAPA - Centre for Aviation & Directorate General of Civil Aviation

This pace of growth will force other Indian carriers to accelerate their expansion to remain relevant.

India GDP Growth and Projections to 2021

Source: IMF World Economic Outlook Database

* Values are estimated

Jet Airways, which had a market share of close to 50% in 2004 could fall to below 10% within two years unless it pursues expansion

The improved economics of the A320neo will further strengthen IndiGo's market position. The carrier's rapid expansion is creating some challenges in terms of on-time performance and crew shortages, but it nevertheless remains highly profitable and the market leader on all counts.

The government's decision to remove the five year qualification requirement for domestic airlines to be permitted to operate international services and to retain only the 20 aircraft threshold, may push Vistara and AirAsia India to expand faster than planned. Vistara could bring forward deliveries to reach 20 aircraft by Mar-2018. AirAsia India's fleet expansion is less certain but the carrier is likely to pursue a more aggressive growth path to remain competitive in the market.

SpiceJet has achieved two years of sustained profitability since Ajay Singh took over the carrier when it was on the verge of closure. This impressive turnaround is reflected in its share price and market confidence. However, with the carrier consistently achieving passenger load factors in the low 90s, the current downward pressure on yields means that SpiceJet has less room to generate additional traffic and instead faces a potential decline in revenue.

GoAir is planning to induct 12 A320neos in FY2018. This marks a significant directional shift for a carrier which has pursued the most conservative growth path in India, reaching a fleet size of just 21 aircraft after 11 years of operations. The fuel efficiency benefits from the A320neo aircraft, combined with sale and leaseback revenue, should enable the carrier to remain profitable in the face of emerging challenges.

International traffic is expected to grow at close to 10% in FY2017 and FY2018, but remains well below its true potential because of bilateral restrictions. Most of the 10 largest international carriers are achieving year round average load factors of 90% or higher, indicating constrained capacity. Without India's unhelpful restrictions, international growth could be in the region of 15%-17% per annum which would result in international traffic volumes doubling within five years. However, demonetisation could negatively impact demand for short haul tourist destinations such as Dubai, Singapore and Thailand.

Several Gulf and Asian carriers are seeking additional entitlements to the tune of up to 150,000 weekly seats. Bilaterals have become a key issue in India's geo-political relations with markets such as the UAE, Qatar, Turkey, Hong Kong, Singapore and Malaysia. The Indian government may only agree to more modest increases than are being sought by some countries.

Meanwhile, India's two largest full service carriers are increasing their focus on international expansion. Air India has been increasing its European and North American network, launching new non-stop services from Delhi to Vienna, San Francisco and Madrid over the last 12 months and a one-stop between Ahmedabad and Newark via London. New destinations under consideration for 2017 include Washington, Toronto, Nairobi, Tel Aviv, Copenhagen and Stockholm.

Jet Airways is focusing on international growth and the Amsterdam hub signals a revival of its long haul ambitions. The re-induction of 10 Boeing 777 aircraft which Jet had sub-leased to other airlines, could be used to launch several new routes. The carrier has been upgauging capacity to Amsterdam and Paris and has entered into extensive codeshare agreements with Delta, Air France and KLM for connectivity to the US and Canada.

LCCs IndiGo and SpiceJet have only pursued modest international expansion in recent times but are expected to grow more aggressively from northern summer 2017. This is also when GoAir plans to commence international services for the first time, connecting destinations in Central Asia, the Gulf, China and Vietnam.

Re-engined narrowbodies have the potential to transform the economics of regional international routes by making more city pairs viable.

Indian carriers are expected to place orders for 250-300 aircraft (including options) in the next three to six months. This will largely be driven by SpiceJet and Vistara, both of whom are expected to stick with Boeing and Airbus respectively for their narrowbody fleet requirements. For long haul operations, Vistara is likely to opt for the Boeing 777X aircraft. New start-ups - including regional and commuter airlines - could order a further 250-300 aircraft if their plans to launch materialise.

Lessor interest in the Indian market is returning as memories of the aircraft recovery challenges experienced following the collapse of Kingfisher start to fade. The strong turnaround by SpiceJet in the last two years have also helped to restore confidence in the market. However, recent regulatory hurdles which have stalled the implementation of the Cape Town Convention in the Indian civil aviation code, despite India being a signatory to the agreement, could impact the country's risk rating.

Improvement in airline financials from 2015 may be short lived. Lower fuel prices combined with modest capacity growth were largely responsible for the improvement in airline financial results in FY2016. IndiGo, Jet Airways, SpiceJet and GoAir all reported record net profits, while Air India enjoyed its first operating profit in a decade.

But FY2017 to date has seen some challenges return as airlines squander most of the benefit of lower fuel through heavy discounting. With India's airlines expected to induct close to 100 aircraft over the next 18-24 months, the increase in supply is likely to maintain downward pressure on fares.

As a result, CAPA estimates that industry profitability in FY2017 will be lower than last year, and possibly significantly lower subject to capacity and pricing in the remaining half.

In FY2018 the industry risks transitioning to a state of profitless growth. India must hope that history does not repeat itself. Between 2004 and 2008, with the onset of liberalisation, India experienced a similar period of euphoric growth driven by low fares. The unsustainable nature of this expansion was exposed as soon as the industry was faced with a fuel price spike, the global economic slowdown and depreciation of the rupee.

What followed was a period of widespread red ink with billions of dollars of losses which led to the failure of airlines such as Kingfisher Airlines and Paramount Airways and almost brought SpiceJet to the verge of closure.

If India's airlines continue to expand without sufficient capitalisation they could face significant challenges when the next external shock hits. And this time the industry is much larger and has further to fall.

Indian carriers are expected to seek to raise USD1 billion of capital in 2017, led by Jet Airways at USD300-400 million. However, the window for carriers seeking capital through IPOs or external funding may narrow as market dynamics are expected to deteriorate over the next 18 months with rapid capacity expansion placing downward pressure on yields, and cost creep visible.

AirAsia India and Vistara are likely to require significant recapitalisation in FY2018 to provide for much larger war chests in the face of strong competition. Following its recent funding exercise in Nov-2016, AirAsia India may need another tranche of capital by 3Q2018 and Vistara may need significant funding once it has taken a decision on acceleration of its fleet expansion.

Another investment by a foreign airline in an Indian carrier is possible but it is dependent upon bilateral policy. However, the Indian government's recent bold decision to permit 100% foreign direct investment in domestic carriers is unlikely to result in any such transactions in FY2018.

Rapid growth is also straining the system, increasing safety and security risks. Skills shortages are emerging and the institutional and regulatory framework at the Directorate General of Civil Aviation and the Bureau of Civil Aviation Security, is particularly weak and under-resourced.

And these issues do not appear to be receiving the urgent attention that they require.

Without investment in new infrastructure, India faces the very real prospect of an airport capacity crisis. Based on projected growth rates, most of the 40 largest airports in the country will exceed their design capacities within the next decade. The situation at key metros such as Mumbai and Chennai is particularly acute.

There is a need to accelerate the award of greenfield airport concessions, many of which - such as Navi Mumbai - have been subject to inordinate delays. The award of the concession for Goa Mopa in Aug-2016 broke a recent drought in privatisation of airports. Nagpur MIHAN and Bhogapuram, could be the next to be decided, with more opportunities expected from 2017.

The policy decision to adopt a 30% hybrid till for all future PPP concessions provides some long overdue clarity on this issue and - together with the strong revenue growth being observed at airports - should result in increased investor interest.

The government's decision to permit 100% FDI in brownfield airports was a bold move but requires further clarity. As noted most of the 40 largest airports in the country will saturate within 10 years and investors will only commit capital if there is clarity on how the second airport concession will be handled in each city as traffic may be insufficient to support two airports.

Elsewhere in South Asia, the government of Sri Lanka has initiated a process to identify a strategic partner for the national carrier. After eight consecutive years of losses at SriLankan Airlines following the termination of the management contract with Emirates, the government is seeking a global partner that can bring capital and expertise to revive the airline and leverage Colombo's strategic geographic location and Sri Lanka's booming inbound tourism traffic.

A liberal bilateral air services agreement with India also creates an opportunity to act as a hub for that market, particularly for southern India. The partner selection process is expected to be completed in early 2017.

Restructuring of Pakistan International Airlines is expected to continue on a piecemeal basis in 2017. The government's attempts to privatise the flag carrier in 2015 were stalled due to union opposition. In the meantime government bailouts will remain necessary.

A fatal accident in late 2016 will not have helped the carrier's efforts to refresh its image, such as the launch of its upgraded PIA Premier service using aircraft wet-leased from SriLankan Airlines. A comprehensive new aircraft order to address its ageing fleet issues is awaited.

In 2017, the restructuring exercise is expected to see non-core business units such as catering, training and engineering, hived off as separate entities. However, privatisation of the airline itself appears unlikely in the near term.