China's Aviation Industry

By Klaus Koehler, Managing Director, Klako Group

Last year, China's aviation industry accumulated RMB 8.69 billion (USD $1.04 billion) in profits upon an annual transport turnover of 120 million passengers, despite the sky rocketing jet fuel prices and airfare price wars. The profits made in 2004 were equivalent to the sector's accumulative profits from the previous ten years. This has been attributed to the bustling economy of China and the fast growing tourism industry. However experts are not sure whether this can be sustained, as China's civil aviation is a special sector controlled by government policies rather than market forces. Plus with competition from overseas and emerging private airlines, domestic airlines need to buy more planes to strengthen their fleets.

Since October 2002, three dominant airline groups have arisen from the General Administration of Civil Aviation of China (CAAC) encouraged consolidation: Air China, China Eastern and China Southern. Guangzhou-based Southern China has become China's largest airline, with 232 aircrafts serving 320 routes on average every day.

It is seen by many analysts and experts that China's commercial aviation industry is crucial to the developments that will sustain continued economic growth and development in China. The World Tourism Organization has predicted that by 2020 China will become the world's biggest tourist destination and the fourth largest source of tourists. It is expected that the air traffic will increase by about 7 percent over the next 15 years. Together with the World Expo in 2010 and the Olympic Games in Beijing 2008, this will also attract an even greater number of tourists and businesses.

As a result the European Union has urged China to open up its aviation industry to foreign countries and foreign investors (if needed) in order to meet the booming market demand. Currently only 20 European and Chinese airlines are allowed to fly between Europe and China, offering flights to 10 Chinese cities and 15 European cities. The total number of flights each week between both sides amounts to only 226 passenger flights and 60 cargo flights.

Airplanes

China has become a battleground for the two largest aircraft manufacturers in the world: Airbus and Boeing. The CAAC has predicted that by the end of 2005, China will have a passenger fleet of 2,800 planes, making it the world's second-largest commercial aviation market after the US. This goal has already begun by Air China signing an agreement with Airbus to buy 20 aircrafts. Followed by Boeing signing preliminary agreements with six Chinese airlines for 60 of its 787 Dreamliners. And then Airbus announcing a deal with China Southern for five of its newly launched A380's.

Airlines

In order to handle the ever growing fierce competition between foreign airlines, who are trying to grab a bigger share of the growing Chinese market, the domestic airlines are beginning to upgrade their services. Air China, for example, plans to invest RMB 688 million (USD $83.19 million) to renovate the first-class and business-class hardware of 15 long-range aircraft before the end of 2005. In the meantime, however, foreign airlines have begun entering the China market one after another.

Spain's Air Europa has launched a direct Beijing-Madrid flight, as well as British Airways which marked its official direct Shanghai-London air route with five weekly direct flights between Shanghai and London's Heathrow Airport. Before 2004, British Airways operated only six direct flights to Beijing weekly.

Beginning in mid-June US-based Continental Airlines, the world's sixth largest airline, launched a daily non-stop air service from Beijing to New York. It has become the only carrier offering daily non-stop service between the two cities. Continental Airlines is the third US airline to enter China's passenger transport market, after Northwest Airlines and United Airlines, since China and the US signed an aviation agreement in 2004. Continental's round trip ticket from Beijing to New York is priced at only RMB 5,288 (US$639), compared with the RMB 5,700 fare offered by Air China. The attractive offer shows the determination of US airlines to win a strong share in the Chinese market. The US carrier also plans to launch a direct Shanghai-New York air route in 2007 and has already submitted its application to the relevant departments.

Meanwhile, United Airlines offers passengers a Beijing-New York return ticket priced at RMB 4,900, with one stop. The airline already has 28 flights to Chinese inland cities each week, is also stepping up efforts to expand its market share. Northwest Airlines joined the price war by selling Beijing-New York round trip tickets at RMB 5,260 (US$636), albeit with two stops.

Chinese airlines, meanwhile, seem a bit passive in facing aggressive foreign counterparts. So far, only state-owned Air China operates Beijing-New York flights. The airline has reported losses each year since launching the air route in 2002. That explains why other Chinese airlines, China Southern Airlines and China Eastern Airlines, hesitate to initiate new air routes between China and the United States. The only Chinese airline to recently announce new service to the US was Hainan Airlines, from Hainan province, which announced plans for direct flights to the US last year.

Issues facing Domestic Airlines

At present, Chinese airlines have adopted a "me-too" policy on international routes. They first study how the foreign airlines operate, then adjust their own operation accordingly. It will take time for the domestic airlines to catch up with their foreign counterparts and learn to compete with them. For example, at the end of 2004, 74 foreign airlines were operating 1,091 flights to China each week, and only eight Chinese airlines were operating 994 weekly flights to overseas destinations.

Another big issue is that jet fuel prices have been rising since June of last year - from 3,400 yuan (US$410) per ton early in 2004 to 4,620 yuan (US$558) per ton now - which have placed pressure upon air carriers. A 100-yuan (US$12) increase in jet fuel prices will lead to a loss of 250 million yuan (US$30 million) in an airlines net profits. For a domestic airline, jet fuel makes up 25 to 30 percent of the operating costs, which is higher than for example a US airline where a major airlines' fuel consumption usually accounts for just 15 percent of its operating costs.

It seems that the logical measure would be increase airfares, however due to the intense competition on domestic routes, the domestic carriers need to offer discounted tickets to lure customers. Not only this but in China, the basic prices of air tickets are set by the government, however airlines are permitted to adjust the prices within a framework. According to CAAC regulations, the air ticket prices are allowed to be 25 per cent higher than the basic prices or 45 per cent lower than the basic prices.

Another problem for airlines is that China's aviation industry is taking off faster than the country can train pilots. There are now 11,000 pilots employed to fly more than 800 aircrafts operated by the domestic airlines. The CAAC has capped the number of new aircrafts to be delivered to airlines this year at 145 in a bid to ensure manageable growth in the industry, but even these new aircrafts are expected to outstrip the capacity of training schools to supply new pilots. The airlines are reluctant to comment on the shortage, but some smaller Chinese carriers have been forced to disregard government policy and recruit foreign pilots as a measure to keep their aircrafts flying at optimum levels. Otherwise airlines have no choice but to cancel services., which has already been the case. While foreign pilots may be a short-term solution, China still needs to find a way to recruit and train pilots for the future as it is estimated that the shortage is between 5000 to 8000 pilots.

Privatization of Airlines

In a move to open the aviation industry, the CAAC has approved several private airlines to operate in China. On March 11th 2005, Okay Airlines, the first approved wholly private-owned airline in China took off from Tianjin Airport carrying a total of 80 passengers traveling to Kunming. The airline, funded by private investors from Beijing and Shenzhen has a registered capital of RMB 300 million (US $36 million). It has been following a low-cost strategy to engage in air cargo and express services, as well as passenger charter and ground distribution services. The main problems that the airline has been incurring are the uncontrollable costs - oil, air material and maintenance - which make up 80% of the an airlines outgoings. The remaining 20 percent includes wages and other fees. Buying airplanes and attracting high-level pilots is another complication for Okay. Okay will need to offer very attractive salaries, which in turn will add onto their costs. Currently, among Okay's 50 pilots, seven are foreign.

Private airlines such as Okay are pioneers of the aviation industry, they still need more policy and governmental support. Issues such as ticket prices, for example, are still heavily regulated by the relevant authorities and private airlines have no advantages in this area compared to the State-owned airlines.

China Airports

Local governments have an obsession with large airports. For example, in the mid-90s Zhuhai in Guangdong Province spent around USD $1,152 million in building an airport designed to serve 12 million passengers a year, when neighboring Guangzhou, Shenzhen and Hong Kong already have new large airports to handle the influx of passengers.

As a result, despite the boom in air travel, only a handful of Chinese airports are making profits right now. It is estimated that there are only about 10 airports in China that are profitable, and some of them only in terms of cash flow. The cause lies in the construction costs and the over-investments made which is not uncommon. However, it is believed that with good management to whip their operations into shape and fast-growing traffic, steady, though not spectacular profits might not be too difficult to achieve. Overall, Chinese airports have pretty good potential to make some money.

It is predicted that China will open 50 airports by 2010, making the total of 220. However, Russia has 1,500 airports and Taiwan has dozens, suggesting there is room for many more airports in China. However, many of the existing airports need to renovate their terminals or build larger ones and domestic transfer desks must open. Currently passengers transferring between domestic flights must exit the terminal, then re-enter to check in again. This arrangement contributes to the long queues typical at major airports. It cannot continue when the numbers of passengers are rising rapidly - 38% last year, to 120 million.

In order to gain profit at the airports, aerobridges, restaurants, advertising, parking, runway lighting and navigation are just some of the many areas with scope for huge improvement. Developing retail is crucial for the development of the airports as well.

Foreign firms combined can own more than half the shares in an airport, as long as the largest single shareholder is Chinese. Therefore many foreign airports have begun to invest in the Chinese airports as they see the potential.

Examples include, the French airport operator Aeroports de Paris bought 9.9% of the shares of the Beijing Capital International Airport (BCIA) and is playing a large role in its expansion projects. A new signature terminal is being designed for the expected increase in passengers for the 2008 Olympics.

Foreigners, however, will earn more money and play a bigger role in Chinese airport modernization through supplying equipment and technology. The best way to get in is to be a supplier of the products Chinese airports need, in design work and materials.
As airports grow they will become the catalyst for change particularly since the CAAC has handed down 70 airports to the local governments. This will lead to regulatory change allowing domestic and international airlines to operate more freely.

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All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.