Yin & Yang

For students of China's rapidly growing
but often puzzling airline industry, at least two developments during 2005 needed no explanation. The landslide victory in early December of the pro-reunification Party in Taiwan's municipal elections sent a clear message that reunification will be a key issue in the country's 2008 presidential election, paving the way for unrestricted direct flights between Taiwan and China.

A few weeks earlier, Siemens AG snared a contract for 60 600-passenger trains capable of speeds of 300 kph for introduction in 2008 connecting China's major cities. Vice Minister-Railways Hu Yadong also announced that express trains with speeds in excess of 200 kph are expected to start running in 2006, flagging significantly greater competition for airlines on short-haul routes.

Since 1997, the speeds of Chinese trains have been increased four times to meet demand. By 2020, China expects to build 10,000 km. of new railway track with 2,000 km. of high-speed track that will include the $12 billion, 1,300-km. Beijing-Shanghai Express. That line will provide an alternative to air travel between two of the nation's wealthiest and most industrialized cities.

While these two developments may be viewed as clear signals, most of the events in China in 2005 sent mixed messages, according to the Centre for Asia Pacific Aviation. In the December issue of its monthly China Essentials, CAPA highlighted the fact that the government-mandated freeze on approvals for new aircraft orders at the start of 2005 was followed by the biggest number of orders in a single year590by Chinese airlines.

At the same time, significant first-half losses at China Southern and China Eastern were turned around miraculously in the third quarter with the help of government policy intervention. Adding to the paradox, a raft of new airlines were approved and the Big Three of Air China, China Southern and China Eastern finalized the process of digesting the July 2000 government-initiated mergers that were designed to rationalize competition and end price wars.

Some of these occurrences reflect the differing policy objectives of CAAC, China's powerful airline industry regulator, and the Beijing government, which confronts international pressure to reduce its trade surplus with the West. For example, early last year CAAC DG Yang Yuanyuan stated, "Chinese airlines have already bought and arranged to be shipped next year a total of 147 planes and this basically suits the needs of the market's growthno additional purchases will be approved in 2005." This declaration was followed by orders and MOUs for five A380s, 60 787s and an even split of 300 A320s and 737s.
More mystery was to be found in the financial results. After a robust 2004 in which China's airlines enjoyed their best profit performance in a decade, the government was forced to assist them in the third quarter of 2005 so they could post profits.

And the size of the turnaround has analysts scratching their heads. The country's largest carrier, China Southern, suffered a CNY964 million ($119.4 million) net loss in the six months to June 2005 compared to a net profit of CNY374 million for the same period in 2004, but in the 2005 third quarter it posted a CNY852 million profit. The story was similar at China Eastern, which suffered a first-half loss of CNY471.4 million compared to a profit of CNY346 million for the corresponding 2004 period and then posted a CNY673 million profit for the third quarter.

These numbers came despite record high fuel prices, greater competition and the costs associated with absorption of a number of smaller carriers into the Big Three. They also contrast with results at Shanghai Airlines, which experienced an 18% decline in third-quarter earnings, and Hainan Airlines, which saw profits fall 71%. According to CAPA, government assistance included de-pegging the currency, placing obstacles in front of new LCCs and absorbing fuel price hikes. But that has not stopped the major airlines' share prices from spiraling downward 20%-50% in the last 12 months.

Bursting At The Seams

China's airlines carried approximately 144 million passengers in 2005, up 20% over 2004; cargo carriage also rose 20% to 3.28 million tons. The strong growth last year built on a 22% rise in passengers in 2004, a year in which the country overtook Japan as the largest air travel market in Asia and second only to the US in terms of total scheduled departing seats, according to the ITTC consultancy division of Airclaims, which is headed by former IATA chief economist Peter Morris (ATW, 5/05, p. 36). It is a pace that Morris views with concern: "There are going to be mistakesthe system cannot grow at this rate without problems."

The government's political agenda in handling this growth may pose the greatest challenge both for private and government-owned airlines and for the foreign carriers eager for a slice of the ever-growing pie. "They are striving for a level playing field but every now and then they tilt it," muses one Hong Kong-based analyst who wishes to remain anonymous. "They are striving to get the yin and yang in balance." Morris says the government is "in favor of liberalization but is concerned with unstable growth," which could be growth that doesn't favor the Big Three.

In January last year, Liu Weimin, director of the Center of Air Law, told ATW that "globalization of the economy is an irreversible and inexorable trend" and that "China's correct choice could be only for win-win." That view was backed up at mid-year by Yang, the highly regarded former China Southern deputy chief pilot, who told media at the May ICAO symposium on airline liberalization in Shanghai that China's airlines will "get bigger and stronger with more competition." He added that the country "will explore new bilateral cooperation and will also learn from foreign airlines' technology and expertise."

More competition is on the way with 96 bilateral air service agreements, including one with the US that will see a tripling of flights by 2010. The latest is a virtual open skies agreement with Singapore inked in November. On the domestic front, the Big Three finally completed the forced digestion of a variety of government-owned smaller carriers last year even as CAAC approved 18 new privately owned airlinesmore than in the previous 10 years combined.
But while encouraging private investment in the sector, the government continues to control aircraft ordering, fare-setting, service levels and route selection. According to CAPA Executive Chairman Peter Harbison, "This presents a major discouragement to investors and to those that have tried to implement a low-cost operating model, many aspects of the model being dropped or deferred until such time as regulatory controls are eased. Okay Airways stated in October it would have to adopt a more conventional airline business model as Chinese government restrictions have made its low-cost model impossible to implement." He adds that Okay President Liu Jieyin complained that after the airline was established, 40-50 airports called on it to open services but permission was refused by CAAC.

Chasing Equity

Foreign carriers chasing equity opportunities in Chinese airlines will be watching these events with unease. At stake is a share in a domestic passenger market that is forecast by Boeing to grow at a rate of 8.8% per year and an international market that will increase by 7.3% annually for the next 20 years, with a resultant requirement for another 2,600 aircraftone every three daysworth $215 billion.

Consummating a successful equity alliance with one of the Big Three is proving to be elusive, as Cathay Pacific has found. It thought that taking a 10% stake in Air China would be the entry fee to securing a freer hand in operating flights to the mainland, but a single daily Hong Kong-Beijing service is hardly an adequate return. Cathay wants hourly services to some Chinese cities like it operates to Taipei. Here is the dilemma that is possibly a window into the true policy reality: Hong Kong has been part of China since 1997, Cathay has significant mainland ownership and an equity stake in Air China, yet it faces a titanic struggle to get a toe in the domestic air route door.

Clearly, says Indoswiss MD Jim Eckes, the Chinese fear the Cathay product. But instead of embracing its expertise and that of Emirates or Singapore Airlines, mainland carriers have shied away from meaningful equity/management tie-ups. This may explain why some of the world's largest air cargo operators have forged significant investments with China's lesser-known aviation names to secure a slice of the burgeoning freight market, Harbison suggests. Noting "potential partnerships" between China Airlines, EVA Air, Lufthansa Cargo, Korean Air and SIA Cargo on the one hand and Okay Airways, Hainan Airlines, Shanghai Airlines and Shenzhen Airlines on the other, he believes they are the result of the "seeming inability by foreign carriers to conclude investment agreements with the Big Three Chinese carriers and the need by the second-tier carriers to obtain fresh investment to fund expansion and foreign expertise to guide development."

The three, meanwhile, appear content for the moment to go with local equity involvement for their expanding cargo operations. For instance, the largest cargo airline, China Air Cargo, is a joint venture among Air China (51%), CITIC Pacific Ltd. (25%) and China Capital Airport Holding Co., parent of Beijing Capital International Airport Co. Ltd. (24%). US cargo operators FedEx and UPS also are going it alone but with significant support from airports such as Guangdong Airport Management Group. CAPA cautions the Big Three that second-tier cargo airlines could, with foreign assistance, "become increasing forces."

The same situation could evolve on the passenger side as an onslaught builds from foreign carriers. Air Canada, Garuda, Philippine Airlines, Finnair, Korean Air, Malaysia Airlines, Air New Zealand, EgyptAir, Dragonair, Delta, Mexicana, Qatar Airways and even Kenya Airlines all announced new or additional services to China in the last quarter of 2005. However, the view in Beijing appears to be that near-double-digit growth will smooth any turbulence for its favored sons.

This is the anticipated outcome of the introduction of direct flights between China and Taiwan expected within a few years. China watchers say that the "explosion of traffic" that would result from truly unrestricted scheduled direct services would more than offset the significant growth in popularity of the railway system as a result of introduction of high-speed trains. Late last year, 72 Lunar New Year charters were agreed that may operate nonstop but through Hong Kong or Macau airspace. The charters will be operated by six Chinese and six Taiwanese carriers between four Chinese and two Taiwanese cities.

The easing of tension between China and Taiwan will be welcomed by Chinese airlines, which are suffering because only 30% of the country's airspace is available to civil aviation, according to Eckes. They must endure indirect routings and lower altitudes, which cost the industry an estimated $1 million a day in extra fuel and lower productivity through longer flight times. Eckes believes the 2008 Beijing Olympics may be the catalyst for easing the restrictions. Some progress has been made. For example, changes to the IATA 1 route connecting North Asia with Europe immediately north of the Himalayas will save 17 min. on each flight.

Chess Game

China's major carriers also may find themselves the sacrificial pawns in the greater game of trade wars, with US and European governments exchanging greater access for their airlines for more access for Chinese imports, suggest some analysts. If this occurs, it will be just another burden for the trio, which already are saddled with mixed fleets of nearly identically capable Airbus and Boeing types to satisfy Beijing's political whims of trading favors.

The question many ask is how these airlines will fare against an unrestricted assault from Cathay Pacific, SIA and Emirates at the premium end of the market and an AirAsia-styled operation at the budget end. Eckes believes "not too well," and many analysts agree. While globally few carriers have the management skills or inflight product of Cathay or SIA, no country is ringed like China by some the world's finest airlines eager to tap its market. Many China watchers think that the Big Three need equity/management tie-ups with foreign airlines and "ponder with fascination" the powerhouse of a full Cathay/Air China alliance, an SIA/China Eastern group and an Emirates/China Southern combo.

What will be fascinating is how the three are going to extract economies of scale after absorbing a variety of airlines. While they now have greater scope, the extent of problems also has increased with inherited debt and yet more fleet types. For example, China Southern has a mixed fleet of 737s, A320s and MD-80s/-90s courtesy of mergers with China Northern and Xinjiang. Some analysts question why these inherited entities were not spun off into LCCs.

But creating LCCs may be a low priority considering the fact that China will overtake the US as the world's third-largest inbound tourism market this year after achieving 41.8 million arrivals in 2004, just 4.3 million behind the US. By 2020 it is expected that the Chinese will be the world's most prolific travelers with 115 million outbound passengers. Predicting how Beijing "will allow" that extraordinary growth to be shared is perhaps the greatest of all the puzzles for which China is so famous. Many analysts gazing into their crystal balls believe that if the government follows the recommendations of Yang, who was awarded IATA's Global Aviation Leadership Award in June, then yin and yang will be in balance.

The Players

Air China China's largest international airline, while outshining its rivals, suffered a 25% fall in profit to CNY591.3 million for the six months to June 30, 2005, on an increase in revenue of 14.6% to CNY16.9 billion. Load factor rose 10.7 points, driven in large part by heavy international demand. Chairman Jiaxiang Li told media that the airline was "able to maintain higher profits through successful cost control and budget management, as well as enhanced marketing efforts." Those cost controls have meant a hold on an anticipated order for the A380 as the carrier focuses on increasing utilization.

Air China is 70% controlled by China National Aviation Holding Co. Ltd., which in turn owns major stakes in Dragonair and Air Macau. It has a fleet of 160 aircraft operating to 72 domestic and 36 international destinations and is on record that it will take delivery of 30 aircraft a year for the next three years. It has consolidated with China Southwest and Zhejiang Airlines and also holds a 25% stake in Shandong Airlines.

China Southern Airlines The country's largest carrier suffered a CNY964 million net loss in the six months to last June compared to a net profit of CNY374 million for the same period in 2004. Revenue leapt 61% to CNY17.8 billion due mainly to the merger with Xinjiang and China Northern. Its media release perhaps summed up the plight of the Chinese industry, saying it faced "new challenges" in a market "full of opportunities." One of the challenges was a slump in yield of 5.2% due to "intense domestic competition." But looking to the future, China Southern committed to five A380s and 10 787s. It has stakes in Shantou Airlines (60%), Guizhou Airlines (60%), Xiamen Airlines (60%), China Postal Airlines (49%) and Sichuan Airlines (39%).

China Eastern Airlines Like its southern neighbor, China Eastern suffered a first-half loss of CNY471.4 million compared to a profit of CNY346 million for the corresponding 2004 period. Fuel was the major culprit, rising 41%, and now accounts for 32% of total operating costs. The carrier has taken over Air Great Wall, China Northwest and Yunnan Airlines and plans to add 40 aircraft over the next two years. It also holds a 40% stake in China Eastern Airlines Wuhan.

Hainan Airlines The rapidly expanding carrier reported a 21% lift in revenue to CNY4.6 billion for the first half of 2005 but net profits fell 88% to CNY10.3 million. Hainan has a very different history from other Chinese carriers, being foreign controlled through financier George Soros's American Aviation LCD. Established in 1989, it began flying in 1993 from its base on Hainan Island and now operates a fleet of 61 aircraft to 52 domestic and three international destinations from its two hubs. In 2005 it added eight 787s and four 737s to its outstanding order book of 24 aircraft and expects to have a fleet of 200 jets by 2010. Last year it took delivery of the first of eight A319s on order. It also moved to set up LCC Lucky Air using 737s from its wholly owned subsidiary Shanxi Airlines and to manage Chongqing Airlines.

Shanghai Airlines This carrier announced plans in December to increase its fleet size from 42 to 100 by 2010. It has an all-Boeing fleet of 737s, 757s and 767s except for five CRJ200LRs. It has ordered eight 787s, three 737-800s and two 767-300ERs and is expected to take some of the huge order for 150 737s placed by the government in November. The airline, which started operations in 1985, serves a host of domestic destinations plus six regional international points. It has a 10% stake in Sichuan Airlines and controls China United Airlines. For the first half of 2005 it made a tiny profit of CNY4.7 million, down 82%, while revenue was up 13.8% to CNY1.18 billion.

Sichuan Airlines Formed in 1988, Sichuan is planning to buy three A330s to launch international services within three years. They will complement its essentially all-Airbus fleet of A319s/A320s/A321s that serve more than 20 domestic destinations from a base at Chengdu. Its shareholders include China Southern (39%), Shandong Airlines (10%) and Shanghai Airlines (10%).

Shandong Airlines Like its sister carriers, Shandong signaled huge growth potential by flagging a doubling of its fleet to 60 by 2010. Based at Jil Nan in Shan Song Province, it was formed in 1994 by 11 state enterprises that hold 64.3% of the stock with the balance in public hands. It serves more than 40 domestic destinations with its fleet of 11 737s and 10 CRJ200s and CRJ700s and also operates to Singapore. Revenue was up 13% in 2004 to CNY1.18 billion but profit slumped 82% to CNY4.2 million. Last June it committed to 15 737NGs.

Shenzhen Airlines The carrier now is controlled by new private investors who have a 65% stake. Air China holds 25%. Shenzhen operates to 46 domestic destinations and Kuala Lumpur with 25 737s and has another five on order. Last year it committed to 25 A320s and A319s.

Xiamen Airlines China's first regional airline was established in 1992 with China Southern holding a 62% stake. It operates an all-Boeing fleet of 29 737s and 757s and last year ordered its first twin-aisle jets with a commitment to three 787s as well as another 15 737s. It flies to 40 domestic and seven Asia destinations.

Taking Flight

Okay Airways China's first LCC is backed by Korean Airlines from which it leases two 737-900s for operations from its base at Tianjin just south of Beijing.

Spring Airlines Launched in July 2005 and based at Shanghai Hongqiao,
the airline is owned by Shanghai
Spring International Travel Service. It operates three A320s to four domestic destinations.

United Eagle Airlines From a base at Chengdu, domestic operations were launched July 26 with four A320s/A319s.

China United Airlines The carrier started up Oct. 25 with three 737s flying from a Beijing base to four domestic destinations. It is owned by Shanghai Airlines and China Aviation Supplies Import and Export Group.

On the Runway

Golden Dragon Owned by East Asia Airlines and Macau businessman Lam Kuo, the airline expects to launch flights early this year with two Embraer 170s from Macau to eight Chinese destinations plus Hanoi and Vientiane.

East Star Airlines Backed by four tourism and property groups, the
carrier will launch operations in May to some 10 domestic destinations. Based at Wuhan, it will have 10 A320s by 2011.

Lucky Air Based at Dali, Lucky is leasing three 737s from Shanxi Airlines for domestic routes. It is a joint venture of HNA Group, Shanxi and Shilin Tourism and hopes to begin flying in the first quarter.

Chongquing Airlines This carrier has been set up by local government-owned Chongquip Land Properties Group and will be managed, subject to CAAC approval, by Hainan Airlines.

At the Terminal

Kunming Airlines, Western Airlines, Northeastern Asia Airlines and Eastern Fastline Airline Co. Ltd. all plan to launch domestic passenger and cargo services toward the end of 2006 or in early 2007.