India's evolving global alliance mosaic: Star/SIA-Tata, oneworld/Air India-Qatar; SkyTeam/Jet-Etihad

It's hard to argue with the assertion that India's international aviation system has been thoroughly dysfunctional.

Constant dithering at central government level, the excessive pressures imposed by vested interests and a series of stop-start regulatory decisions have conspired to ensure that India's undoubtedly enormous aviation potential would not be reached. Even the simplest look at the country's geography makes it obvious that Delhi and Mumbai could, in an enlightened regulatory regime, have been among the world's leading international hubs.

Instead, a litany of uninspiring, supposedly protectionist, measures have ensured that even the aviation hubs serving India's own international market have been outside the country - first in Sri Lanka and Germany, today more in the Gulf airports. To achieve such an outcome has required enormous ingenuity.

Yet now, in response to a momentum initiated by an aggressive and forward looking move by Etihad investing in Jet Airways, it looks at last as if despite itself, India's government may be stumbling into a position where rationality and a benevolent outcome might open up.

A long overdue move to relax foreign ownership rules, allowing the possibility for foreign funding and expertise to enter the market, has quickly seen Etihad move, followed shortly after by AirAsia and Singapore Airlines also announcing proposed roles in India's airline industry.

International traffic to/from India could reach 100 million passengers by FY21

Despite the structural challenges in the market, international traffic to/from India has been a strong and steady performer over the past decade, growing at a CAGR of 11.3%, remaining positive every year, even during the economic downturns. In the four months to 31-Jul-13 international traffic was up 11.0% year-on-year, in line with CAPA's projection of 10-12% growth for FY14 announced at the start of the year. Outbound growth was even faster, despite the steep depreciation of the Rupee.

India international passengers movements FY03 to FY13

Source: CAPA - Centre for Aviation and Airports Authority of India

CAPA projects that over the next ten years international traffic could grow to reach 96 million passengers by FY23. However, this assumes the current regulatory environment. If the 5/20 rule was lifted this could result in a significant acceleration of growth and the 100 million mark may be reached by FY21.

This would represent an outbound traveller market of approximately 35 million, and around 15 million inbound tourists.

India's low base suggests that the growth potential is huge. The market ranks 6th in the world for domestic seat capacity but drops to 19^th for international. On a per capita basis the number of seats is by far the lowest among the 20 largest international markets, and less than half that of China.

International Seat Capacity per capita for the 20 largest international markets

Source: CAPA - Centre for Aviation and Innovata

Note: Annual capacity is calculated as 52x the weekly capacity for the week beginning 6-Oct-13, the actual capacity for the year may vary due to seasonal variations.

Abolition of the discriminatory 5 year/20aircraft rule could unleash India's international traffic potential

The remaining road block is another lopsidedly protectionist measure that prevents Indian registered airlines from flying internationally until they have been operating domestically for 5 years and operate more than 20 aircraft. Meanwhile, no such restriction applied to foreign airlines operating into India; this rule was purely to protect the Indian incumbents from home bred competition.

Indeed several carriers currently operating to India, such as Air Arabia, Etihad, flyDubai, Mihin Lanka, RAK Airways and Tigerair, first entered the market well before they had been in operations for five years (as did several other carrier that have since withdrawn from the market such as Bahrain Air, Jazeera, Jetstar Asia, Nok Air, Safi Airways, Sama). These airlines have since grown to capture around 12% of international traffic to/from India carried by foreign airlines. Air Arabia, which operated to India in its first year of operations is now the third largest foreign carrier in the market. Meanwhile several home carriers of a similar vintage to these foreign airlines were prevented from competing with them.

The impact of this discriminatory regulation has been extremely damaging for Indian aviation. Not only has it ceded a larger share of international traffic to foreign carriers, but it contributed to over-capacity and losses in the domestic market during market downturns because some Indian airlines were unable to re-deploy aircraft to overseas routes.

And Kingfisher's demise can in part be attributed to the challenges of integrating Air Deccan, an acquisition that was motivated by the desire to circumvent the 5/20 rule. By leveraging Air Deccan's longer history of operations, Kingfisher was able to launch international services almost two years earlier than it would have been able to in its own right. But that decision marked the start of the carrier's problems which eventually led to its closure.

Abolition of the 5/20 rule is clearly in India's national interest. The implications could be far-reaching. GoAir, the only incumbent carrier which does not yet qualify for international services would be permitted to go abroad, but perhaps more significantly so too would the two new ventures announced this year, AirAsia India and Tata-SIA, as well as other start-ups. Both carriers have made clear their interest in launching international services, and given their ties to strong airlines in Southeast Asia they have the potential to develop formidable networks.

Regional international markets would see the most rapid growth

LCCs are expected to be the key drivers of international growth, especially if the 5/20 rule is lifted. This will result in particularly strong capacity expansion on routes to the Gulf, and South and Southeast Asia which account for 75.4% of international capacity. Key destinations will be Singapore, Bangkok, Kuala Lumpur, Kathmandu, Colombo, Dubai and other Gulf destinations.

However the next phase of growth is also likely to include the launch of routes to secondary leisure destinations in Southeast Asia, such as Phuket, Chiang Mai and Langkawi.

International seat capacity to/from India by region, week commencing 6-Oct-13

Source: CAPA - Centre for Aviation and Innovata

New aircraft technology could change regional international dynamics

The introduction of re-engined narrow body aircraft such as the A320neo and the 737 MAX in the latter part of the decade could enhance the viability of narrow body equipment on longer regional routes of six hours or more. This would open up the possibility of LCC services from Delhi/Mumbai to points such as Singapore, Jakarta, Manila, Hong Kong, Shanghai, Moscow and Istanbul, or from Mumbai to Mauritius and Nairobi. And through partnerships with other carriers, one-stop LCC services would be possible to destinations stretching from Europe to Australia.

IndiGo's recent decision to convert 20 A320neo orders to the larger A321neos (which can accommodate up to 56 additional seats in high density configuration) will enhance its competitiveness against wide body operators on key routes and could enable IndiGo to become a major international player. Other carriers may also consider inducting the A321neo or 737 MAX 9 to better compete in the short haul international market.

India could finally leverage its potential as a long haul low cost hub

India possesses a huge home market, an advantageous geographical location and, if and when the necessary fiscal and regulatory reforms take place, a potentially low cost structure. These are the core ingredients for a potentially powerful long haul low cost hub serving not only the point-to-point market to/from India, but acting as a bridge for low cost services between Europe, Africa, the Middle East and Asia.

The 5/20 rule has prevented such an opportunity from being realised since any start-up carrier with plans to launch a long haul low cost carrier would first have to operate a domestic airline and then entirely change its fleet and network strategy after five years.

AirAsia India could establish an international base in Cochin operating high density routes to the Gulf which are dominated by price sensitive expatriate labour traffic. The availability of affordable and reliable air services between Kerala and the Gulf has long been an important objective for state politicians.

Air India's international low cost subsidiary, Air India Express, was established in part for political reasons and Kerala accounts for the majority of the carrier's capacity. But an airline born out of meeting political end is unlikely to deliver commercially. The carrier lacks a dedicated corporate structure while being neglected by its parent. And the focus on Kerala means that other important markets across the country have been left open to Indian or foreign LCCs to develop.

But despite this commitment to Kerala it is still not seen as being in line with requirements by the state government, which has been preparing to launch a competing low cost airline, Air Kerala. The launch of this carrier has been hampered by the 5/20 rule, but once this restriction is lifted the state government may not need to proceed with its own venture if AirAsia is prepared to establish a base at Cochin. Such a development would be a body blow to Air India Express, but would give wings to the growth of Cochin Airport.

Air India's return to profitability is ruled out; privatisation is now a certainty and will be a priority on the agenda of the next government

Despite the fact that Air India's performance has improved significantly across operational, commercial, customer service and financial metrics under the current management team, we rule out the possibility of Air India's return to profitability under its current ownership structure given the underlying structural problems and fast changing market dynamics.

Air India is already bleeding on international routes and the lifting of the 5/20 rule will only compound the situation. Intense competition from LCCs will make short haul regional international markets very tough for Air India for which it does not have the appropriate fleet. While long haul services have to compete with formidable sixth freedom operators, a strengthened Jet Airways, a new Tata-SIA and possibly even long haul LCCs.

And the segment in which Air India has a unique market proposition, on non-stop services to the US, is extremely difficult to make viable given current fuel prices. Even Singapore Airlines, with its strong business and first class markets, is withdrawing from ultra long haul routes.

Other challenges for the carrier include the incompatibility of its fleet with its network and commercial capabilities; securing membership of an alliance and underlying labour issues.

With the carrier expected to post continued losses, the next government which takes office in 2014 must finally bite the bullet and commence the privatisation of Air India. If the government is prepared to privatise all of the Airports Authority of India's profitable airports there appears to be no reason to hold on to the loss-making national carrier.

Paving the way for alliances - global and otherwise - to establish in India

Although the headline suggestions of Star using a Tata-SIA combination as vehicle, Air India linking with oneworld and an Etihad-centric but SkyTeam-related grouping are mostly still speculative, these next steps are now coming into focus.

Alliance shares of international seat capacity at Indian airports week commencing 6-Oct-13

Source: CAPA - Centre for Aviation and Innovata

This does leave Emirates, India's largest foreign operator with no immediate partner. Arguably, Emirates is however sufficiently well entrenched, and could soon have access to a significant increase in seat entitlements, not to need a local partner, although potential LCC partners abound and the domestic market is now essentially a budget operation.

Airline-wise market share of international traffic to/from India in FY13

Source: CAPA - Centre for Aviation and DGCA

The potential for Star Alliance to adopt a new SIA-Tata airline as its Indian member

The recent announcement of the Tata-SIA joint venture opens up the potential for a Star-aligned operation in the Indian market. With the Tata group's brand reputation and place in history as founders of Air India in 1932 (which they ran until the carrier was nationalised in 1953), its return to the sector has been widely acclaimed. The venture is politically palatable, viewed as an Indian-promoted airline expected both to deliver the very high standards for which the two joint venture partners are recognised, and also to focus on developing a network based on an Indian hub. Singapore Changi is also seen as less of a threat to Indian hubs, as much of India's traffic is westbound and, increasingly in future, northbound.

However the greatest remaining impediment to the development of Indian international carriers has been the self-inflicted 5 year/20 aircraft rule. The current Aviation Minister now states that the rule is unnecessary and damages the interests of Indian aviation, introducing the very real prospect of change. If this restriction is lifted it will provide a further boost to international traffic, by allowing existing carriers such as GoAir, as well as Tata-SIA and the AirAsia-Tata JV - and other potential start-ups - to launch international services from day one.

With a relatively weak Air India and with Jet Airways focused on the Abu Dhabi hub, this creates a space for competitive Indian carriers, both full service and low cost, to offer international point-to-point networks as well as developing sixth freedom traffic flows.

In terms of aviation accessibility, India's geographic location is comparable almost to that of the UAE, but the lack of adequate airport infrastructure or a strong home carrier have meant the opportunity was squandered. This now has the potential to change. AirAsia has also stated that is keen to launch long haul international services from India as and when regulations permit, and there is even the potential to establish a low cost long haul hub between Asia and Europe. These are realistic - and potentially transformational - prospects within the 8 hour maximum flight stage scope favoured by Asia's existing long haul low cost operators.

Singapore Airlines could also potentially interline with Tata-SIA in Delhi to access the US East Coast, which it has struggled to do viably on a non-stop basis from Singapore, recently withdrawing its all-business class non-stop operation. Routings via Delhi are very efficient, with SIN-DEL-NYC being only 3.8% further than non-stop, and Toronto 5.3% longer. This does not have the cachet of the Gulf carriers' non-stop to anywhere capability, but it may also enable SIA access smaller markets in the Middle East.

Can oneworld help a struggling Air India?

Aside from the government's chaotic regulatory history, the most intractable problem confronting India's aviation industry is its sadly depleted flag carrier. Battered by inadequate investment, persistent meddling, constant leadership changes, network muddles and gross over-staffing, the airline is today a sad shadow of what could have been.

That the carrier invested two years and millions of dollars in preparation for membership of Star Alliance and was still rejected at the final hurdle is an indication of how far Air India had fallen in the estimation of global airlines back in 2011.

Worse still, it casts its dark shadow across the entirety of India's airline industry. No government in the past two decades has had the courage either to capitalise the airline sufficiently to allow it to be competitive, or to put it out of its misery. Subsidised to the tune of nearly a billion dollars a year, Air India in its present form is treading water, diverting funds from much needed public works and infrastructure.

The carrier continues to incur huge losses on its international routes as its fleet is poorly matched with its route network and commercial capabilities. It has not been able to profitably deploy its 777-200LRs as it cannot generate sufficient premium traffic to support the high trip cost of this large aircraft. As a result, despite being designed for long range service, the aircraft are being sub-optimally deployed on medium haul routes.

Air India has been unable to sell these aircraft, while its ageing 747-400s are being retired. That leaves it with the 777-300ERs and the new 787s. The 787 has shown good results for Air India so far, as the routes where it has been deployed have at least been cash positive. However, after all outstanding aircraft on order are delivered over the next couple of years, Air India will have a wide body fleet of just 42 aircraft.

The carrier operates narrow body aircraft on some regional international routes, but the A319s which represent some 60% of its active narrow body fleet often face payload restrictions. There have been significant improvements in the last 18 months but without adequate government funding, with competition intensifying and labour and political issues never far below the surface, focussing on long term competitiveness must give way to short term survival.

Having failed in its bid to join Star Alliance two years ago Air India recently advised the alliance that if it were not admitted by Oct-13 it would pursue other options. In light of the Tata-SIA venture, membership of Star Alliance does not seem likely in the near-term. The alternatives are not numerous, but the new flurry of activity in India has provoked Qatar Airways to offer to sponsor Air India for membership of oneworld. But alliance membership alone is not a solution.

Instead there is a need for some form of rescue package with the potential for a more efficient and possibly expansive Air India.

Jet Airways' partnership with Etihad opens up a vast network to Indian passengers, but Indian airports now need a hub carrier to fulfill their potential

Then there is Etihad-Jet. Having now received approval from the Cabinet Committee for Economic Affairs, Jet Airways can now become part of Etihad's "Equity Alliance". Etihad is not part of SkyTeam, but it has aligned substantially with the group's European leader Air France-KLM and with its African operation in Kenya Airways. It would presumably be within reason that Jet could establish closer ties with SkyTeam in its own right, perhaps even with the encouragement of Etihad.

Jet Airways is the largest international carrier by traffic to/from India (Air India is largest by seats according to Innovata but has a lower load factor), and with a strong reputation for service, has arguably the greatest potential to develop as a global network carrier based in India, particularly in light of the significant improvements in airport infrastructure at Delhi, and shortly at Mumbai.

However, its partnership agreement with Etihad will see it focus on using Abu Dhabi as a hub for most Westbound routes, consolidating traffic from 20 cities across India into Abu Dhabi and onwards to the Middle East, Europe, the Americas and Africa. With fewer non-stop destinations offered directly from India this represents a major blow to the hub ambitions of India's airports.

With other Gulf carriers having shown interest in India's LCCs and even possibly in a non-equity partnership with Air India the axis was very much shifting to the Middle East with the very real prospect of Indian carriers become regional feeders for Gulf airlines and airports, with significant implications for India's long term aviation development. However the Tata-SIA venture, approval of further start-ups and the abolition of the 5/20 rule would significantly re-balance the market.

Approach to airport development and operations will have to change

Possible developments such as the lifting of the 5/20 rule, the rise of long haul LCCs and the induction of Indian carriers into global alliances will have a significant impact on the airport traffic mix, with implications for how airports should be developed and operated. International terminals that were primarily designed for full-service wide body operations will need to consider how best to accommodate the needs of a growing share of low cost and narrow body operators. While alliance members will seek co-location within terminals and the ability to establish branded, shared facilities.

The changing market structure in turn has implications for passenger mix, which influences retail spend and the need for facilities such as lounges and food and beverage outlets.

Increasing affordability of international air travel as a result of the growth of LCCs will drive demographic changes by enabling more first time travellers and young passengers to enter the market, each with their own unique needs. Where the first time traveller may need human touch points to guide them through the airport, younger travellers are more likely to be comfortable with technology solutions such as self-service and mobile platforms.

The changing nature of the international market could trigger the opening of integrated domestic/international LCC terminals at Delhi, Mumbai and Chennai.

Some reforms may be accidental, but the outcome will be positive

The unprecedented opening up of the India-Abu Dhabi bilateral agreement just hours before the announcement of the Jet Airways-Etihad deal created a negative perception of how aviation is managed in India and resulted in a political uproar.

This may in turn have prompted the decision to fast-track approvals for AirAsia, and likely for Tata-SIA and others, as well as the growing momentum to remove the 5/20 rule in an effort to re-balance the market. If the consequence is the dismantling of some of the key structural challenges in Indian aviation the outcome will be highly positive for the sector:

• Traffic growth will be unleashed delivering benefits for trade, tourism and employment generation;
• Indian carriers will have the opportunity to become financially stronger as a result of growth and more efficient capacity allocation;
• As Indian carriers strengthen and seek to expand internationally, bilaterals can be further liberalised;
• Airports will not only benefit from increased market access and traffic growth but there will be improved prospects for hub development;
• Investor interest in the 15 airports which the AAI plans to offer on a PPP basis could increase.
• Carriers such as GoAir and SpiceJet may become more attractive to potential investors.

Foreign airline investment and the lifting of the 5/20 rule will in particular have a lasting and positive impact on the outlook for Indian aviation. In India's unique environment none of this should be taken for granted; but an opportunity exists now that could be transformative.