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Russia: external setbacks highlight the need for reform

Airline Leader

A quarter of a century after the demise of the Soviet Union, the Russian state retains a central role in all areas of economic activity. Its actions continue to be catalytic agents of change in the country's aviation sector.

Summary
  • The Russian government's policies have had a significant impact on airline consolidation, low fares business models, and the balance between domestic and international traffic growth.
  • The economic recession and sanctions have led to a decline in air passenger numbers in Russia, particularly in international traffic.
  • The Russian economy is expected to remain in recession in 2016, with negative GDP growth forecasted.
  • The consolidation of the airline market in Russia has led to increased

Airline consolidation, the emergence of the low fares business model, the balance between domestic and international traffic growth and whether or not there is any growth have all been strongly influenced by government policy. Aeroflot's dominance owes much to government policy, which may now also lead to further changes in the airline's ownership.

But this needs to be part of wider economic reforms, including further deregulation of Russia's aviation market.

Before oil prices started to tumble in 2014, Russia relied on oil and gas revenues for more than half of its budget. The slump in hydrocarbon prices since then has left a damaging hole in the national accounts. According to investment banking arm of Russia's biggest bank, state controlled Sberbank, Russia will generate little more than a third of its revenues from oil and gas if Brent crude averages USD30 per barrel.

Privatisation of state owned assets has recently returned to the agenda as President Putin looks around for sources of cash to plug the gap. The sale of state owned organisations ended up with a bad name after a spree of transactions in the 1990s led to huge wealth for a small number of oligarchs amid suggestions of corruption.

Nevertheless, Mr Putin is reportedly considering a new wave of privatisations. This could even lead to a further sale of shares in Aeroflot, which is already stock exchange listed, but currently still majority owned by the Russian state.

According to the International Monetary Fund (IMF), Russia's economic output, as measured by its GDP, contracted by 3.7% in 2015. This severe recessionary year followed a number of years of slowing growth, with GDP increasing by only 0.6% in 2014, after growth of 1.3% in 2013 and 3.4% in 2012.

One of the consequences of the economic and political risks faced by the country has been an end to inward foreign investment, leading to a significant amount of capital flight from Russia. According to the nation's central bank, capital outflows totalled USD57 billion in 2015, down from USD153 billion in 2014 and less than expected at the start of 2015. This at least suggests the situation is easing. A similar figure is expected in 2016 as in 2015.

Falling oil prices and capital outflow have had a punishing impact on Russia's currency. The RUB fell by 44% versus the USD in 2014 and a further 19% in 2015. In the first four weeks of 2016, it was down 7% more, making it worth only 42% of its end 2013 value against the USD.

Consumer price inflation was almost 16% in 2015 and is forecast by the IMF to be at a still high 8.6% in 2016. The benchmark interest rate is 11%, compared with 5.5% in early 2014. With a rising budget deficit (the budget was based on USD50/barrel oil, not the USD30 oil that Jan-2016 has witnessed) and sanctions preventing the Russian government from borrowing on the international debt markets, the country looks set for more tax increases and public spending cuts.

Although its economy may be past the very worst, Russia is expected to remain in recession in 2016. The IMF's Jan-2016 update forecasts Russian GDP will shrink by 1.0% in 2016, a downward revision from its Oct-2015 forecast of -0.6%.

Moreover, this outlook for Russia is in sharp contrast with the IMF's average emerging market forecast of 4.3% GDP growth in 2016 (following estimated growth of 4.0% in 2015). The IMF expects Russia to return to growth in 2016, but only at a sluggish rate of 1.0% (no change from its previous forecast).

Sberbank CEO Herman Graf has identified three main causes of Russia's economic malaise. In addition to the collapse in oil prices and the imposition of sanctions by Western powers opposing Russia's 2014 military incursion into Ukraine, the government's failure to diversify its economy has also contributed to the slump.

In an interview with the Financial Times published on 02-Feb-2016, Mr Graf identified which of the three factors has been the most damaging. He said: "The key problem now is the dire need for structural reforms because even if the oil price increases and sanctions are lifted, if reforms are not implemented there will never be high growth".

In spite of the weak growth in Russia's economy in 2013 and 2014, growth in the number of air passengers remained robust in those years. From 2009, the depth of the global financial crisis, to 2014, passenger numbers increased at a compound average growth rate of 14.6% p/a, with both international and domestic traffic enjoying a similar average growth rate.

Traffic grew by 13.2% in 2013 and 7.8% in 2014, slower than in the immediate aftermath of the crisis, but still very healthy growth by global standards.

However, air traffic in Russia could not escape the impact of the country's economic recession and sanctions in 2015. In the first nine months of 2015, passenger numbers fell by 2.6% year-on-year.

International traffic led this traffic decline, dropping by 15.3% in 9M2015, as demand felt the impact of the geopolitical environment and foreign airlines withdrew capacity in the wake of sanctions. International traffic had already started to slow in 2014, when it increased by only 1.8% after several years of double digit growth.

Some of the drop in international traffic in 9M2015 was offset by continued growth in the smaller domestic market, where passenger numbers increased by 16.2%.

Russia's air traffic market has enjoyed a significantly higher multiplier between traffic growth and GDP growth than the long term global average of around two times. This reflects the fact that Russians have a lower propensity to use air travel compared with developed markets.

Nevertheless, the current economic outlook, as encapsulated in the IMF forecast of another year of negative GDP growth in 2016, means that passenger numbers may well also experience another year of contraction.

Indeed, at the time of writing in early Feb-2016, schedules data for 2016 indicate that seat numbers will be down by 15% to 20% in most weeks for which capacity data from OAG are available so far (up to early Jul-2016). If the economy returns to growth in 2017, even sluggish growth, there is a reasonable prospect that air travel may resume its previous expansion.

In its favour is the under-penetration of air travel in Russia, which means that there is a structural trend towards an increasing propensity to fly and this is not only driven by the economic cycle.

Working against this currently and in the foreseeable outlook are low oil prices, a negative for a net oil producing nation, and the geopolitical environment.

Russia's annexation of part of Ukraine, and the subsequent economic sanctions imposed by Western powers, and President Putin's contrasting stance compared with many of them on the civil war in Syria are just some of the factors creating uncertainty over future levels of demand for air travel to/from Russia.

The process of consolidation in Russia's airline market continued in 2015. This has led to considerable concentration in the Russian market, with the share of passengers of the top five Russian groups increasing from 60% in 2010 to 81% in 9M2015 (note: this is the share of passengers carried by Russian airlines only). This consolidation has been driven by a government directed wave of acquisitions by Aeroflot in 2011 and more recent difficulties encountered by some of its larger remaining rivals.

As a result, Russia's leading airline group grew its share of total passenger numbers (carried by Russian and foreign airlines) from 20.5% in 2011 to 35.2% in 9M2015.

The Aeroflot Group's 35% share of passengers in 9M2015 compares with a 30% share for the same period only a year earlier. By contrast with the 2.6% contraction in the wider market, it carried 13.3% more passengers in 9M2015 versus 9M2014. For the full year 2015, the Aeroflot Group achieved a similar growth rate, 13.4%, driven by a 32.5% increase in international passengers, more than offsetting a 6.2% fall in domestic traffic.

Aeroflot's share of traffic benefited particularly from a 17.1% fall in passenger numbers carried by number four ranked UTAir Group, a 16.3% decline for Russian airlines outside the top five and a 19.5% drop in traffic for foreign airlines to/from Russia in 9M2015.

Number two ranked Transaero's AOC was suspended on 26-Oct-2015 after the collapse of various attempts to rescue it from bankruptcy (including a government directed plan for Aeroflot to acquire a majority stake). Nevertheless, Transaero still managed a 2.9% increase in passenger numbers in 9M2015.

Although no longer needing to acquire the whole company, Aeroflot has taken on some of Transaero's aircraft, staff and routes. This will further boost the market share of Russia's leading airline group in 2016, particularly given the still shrinking size of the overall market.

In spite of a two year period of expansion by foreign LCCs on routes to/from Russia in 2013 and 2014, LCCs still had less than 5% of seats on these routes in 2014. No frills airlines such as easyJet, Germanwings, NIKI and flydubai all added routes and capacity to Moscow in 2013 and 2014, attracted by the growth potential in the Russian market.

However, in 2015, much of this foreign LCC activity was scaled back. For example, easyJet withdrew from Manchester-Moscow in Sep-2015 and reduced London-Moscow capacity twice during 2015 (it plans to cease London-Moscow altogether from Mar-2016).

The reversal in traffic on international markets meant that the LCC share of seats to/from Russia dropped to less than 4% in 2015 (source: CAPA - Centre for Aviation and OAG). The highest ranked foreign LCC by seats for Jan-2016 is flydubai, which is only at number 14 in the list of all airlines by international seats to/from Russia, while for Jul-2016 it is Vueling, which is only at number 10 overall.

The decline in foreign LCC capacity to Russia coincided with the emergence and growth of domestic LCC capacity, which was the result of legislative change. Previously, regulation on matters such as the minimum fleet size for new airlines, the sale of non-refundable tickets and the unbundling of product features had made the development of the low fares business model practically impossible.

The Aeroflot Group took advantage of changes to legislation to establish its first LCC subsidiary Dobrolet in 2014. However, this short-lived operation was grounded as a result of EU sanctions and Aeroflot established Pobeda in Dec-2014 as its successor.

Pobeda, which remains the only LCC in the domestic Russian market, carried 3.1 million passengers in 2015. This was nearly 8% of the Aeroflot Group total. Based on seat capacity for the week of 01-Feb-2016, Pobeda is the number five ranked airline in the Russian market (source: OAG).

As the only LCC in Russia, it seems likely that Pobeda's impact has mainly been to grow the market. Data from the Aeroflot Group concerning load factors at Sochi, where all three of Pobeda, the parent airline and the group's regional operation are present, support its assertion that Pobeda has helped the group to segment the market without cannibalising sales from its existing airlines.

At Sochi, Pobeda had a 9M2015 load factor of 82.5%, compared with 80.8% for Aeroflot and 83.9% for regional airline Rossiya. Passenger numbers were also fairly evenly split between the three brands (395,000 for Pobeda, 481,000 for Aeroflot and 491,000 for Rossiya).

After a year operating only on domestic routes, Pobeda launched its first international routes, from Moscow Vnukovo to Bratislava and Milan Bergamo in Dec-2015. It will launch Moscow-Cologne in Feb-2016 and also plans services to Vienna and the Belarus capital Minsk.

There are features of the Russian aviation market that are consistent with the relatively closed nature of the country's economy. For instance, local carriers operate 85% of all movements and 100% of domestic movements. This is a much less open market than other large countries in Europe.

As examples, local airlines account for 58% of movements in Germany and 55% in the UK. In Poland, local carriers have only 32% of movements.
Russia's air passenger market is also much more dependent on domestic traffic than is the case for other European countries. Almost 54% of airline seat capacity that touches Russia is deployed within its borders, compared with 16% in Germany, 10% in the UK and 8% in Poland.

Russia is the largest European country that is not part of the European Union's liberalised aviation market and this restricts access to foreign carriers. Equally, Russian airlines' access to EU markets is also reciprocally restricted.

The impact of such restrictions is currently exacerbated by lower demand from international travellers and capacity reductions by foreign airlines. The current economic and political situation facing Russia is making its aviation market even more inward looking and isolated.

The composition of the combined fleet of Russia's airlines also reflects the relatively closed nature of the market. According to the CAPA Fleet Database, fewer than 7% of aircraft operated by Russian airlines are widebodies. This compares with almost 14% for Europe as a whole and 17% globally.

Moreover, out of the total of just 62 widebody aircraft in Russia, 38 are part of the Aeroflot Group's fleet (including three at its Orenair subsidiary). This is more than 60% of the total. Cargo airline AirBridgeCargo operates 15 freighter widebodies, but no other passenger airline has more than five.

Although it is underweight in widebody aircraft, the percentage of narrowbodies in the Russian fleet, 48%, is broadly in line with the European average of 52% and the global figure of 49%. However, Russia is significantly overweight in smaller aircraft types. Turboprops make up 19% of its fleet, compared with 11% both for Europe and globally. Regional jets account for 15% of the Russian fleet, versus 11% in Europe and 13% across the globe.

Russia's civil aircraft fleet also differs from those of other European countries in that domestic airframe manufacturers account for a significant proportion of the fleet (more than one third).

The importance of narrowbodies and smaller aircraft types to Russia's fleet not only reflects the significance of the domestic market (remember, too, that Russia is geographically the largest nation on earth), but also the relative proximity of much of Asia, which is a long haul market for much of the rest of Europe.

Not surprisingly, the Aeroflot Group's fleet is by some distance the biggest in Russia. As at 31-Jan-2016, it consisted of 266 aircraft in service, making up 28% of the nation's entire fleet. The group's 116 aircraft on order account for 38% of all orders by Russian airlines. Aeroflot orders are fairly evenly divided between Airbus and Boeing and for both narrow and widebodies and also include six Sukhoi regional jets.

The other three Russian airline groups in the nation's top four have a combined fleet of 177 aircraft, only two thirds that of the Aeroflot Group fleet. The 76 outstanding orders collectively made by the three represent a similar fraction of Aeroflot's orders.

Number two airline group UTAir Group has a fleet of 97 aircraft in service, well under half the size of the Aeroflot Group's fleet. UTAir's 46 orders are with Airbus (eight A321s), Boeing (28 737NG aircraft) and Irkut (10 MS 21 narrowbodies). S7 Airlines has 45 aircraft, with 23 A320s on order, and Ural Airlines has a fleet of 35, with seven A320 aircraft on order, according to the CAPA Fleet Database.

Outside the top four groups, there are only four operators that currently have outstanding orders for 10 or more aircraft, primarily for smaller aircraft types with Russian manufacturers. Yamal Airlines has 17 orders (with Sukhoi) and three airlines have 10 aircraft on order: VIM Airlines (with Tupolev and Bombardier), Red Wings (with Tupolev) and IrAero (with Irkut).

Significant developments in Russia's airline market depend on government and regulatory intervention more than elsewhere, certainly when compared with countries that are part of the European Common Aviation Area's single market. Increasingly, such developments revolve around the Aeroflot Group.

Although Aeroflot is a publicly listed company, with shares floated on the stock exchange and private investors in its share register, the Russian state retains a 51% controlling stake, at least for now.

The consolidation process led by Aeroflot was essentially directed by the Russian government, which exercises a "national champion" approach to its airline sector (as in other sectors). The resultant market concentration has benefited Aeroflot, as have changes to laws that facilitated the development of LCCs.

If the Russian state sells down its holding in Aeroflot to a minority position, or even exits the share register altogether, this could pave the way for further change in the country's aviation markets.

It seems highly unlikely that the government would leave its national airline's fate entirely in the hands of private investors, but its need to raise cash is compelling. A change in Aeroflot's ownership structure could potentially even lead to investment from a foreign airline, with possible consequences for its strategic development, including its partnerships and alliances.

The Russian state needs to raise cash; at the same time it is essential to implement structural reforms to the economy. There are well recognised relationships between growth in air traffic and growth in GDP and between the liberalisation of aviation markets and air traffic growth. The privatisation of Aeroflot and further deregulation of Russia's aviation sector must be on Mr Putin's agenda in 2016.