Five years after China opened its air market to private operators, the fortunes of these new players remains constrained by a host of market impediments, writes Jane Pan in Vancouver
Chinese air transport history was made in 2005. This was the year when the Chinese government opened its monopolised civil aviation sector to private investors for the first time. And the response was overwhelming. Within two years, the number of private airlines climbed to eight, with Okay Airways, Spring Airlines, United Eagle and East Star emerging as the largest and most competitive players.
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The underlying reasons for the unsatisfactory state of China's private airlines goes beyond the global economic downturn. Before the acquisition of United Eagle, China's four main private airlines collectively operated about 85 routes using 40 aircraft. This is less than 5% of the total number of aircraft and routes operated by the "Big Three": Air China, China Eastern and China Southern.
Five years after a strong start, China's private airlines remain negligible players, confined by a market share which is too small to have any meaningful impact on the market (see table above). Failure to achieve organic growth is a key reason why they did not manage to break up the civil aviation monopoly. But the essential resources for achieving such growth - namely capital, routes, aircraft and pilots - are beyond their control. "We're like soccer players with our hands and feet tied up when playing a game," is how one senior manager from a Chinese private airline describes his company's struggles. China's civil aviation market may have opened up, but the policy environment still slows private airlines' ability to grow.
If capital is the lifeblood needed to keep an airline alive, many privately-owned Chinese players have needed an infusion from the outset. The minimum start-up capital of 80 million yuan ($11.7 million) required by the Civil Aviation Administration of China is far from enough to keep a new airline alive in the first two to three money-burning years while they strive to reach break-even. Banks are also reluctant to lend to private airlines, which have little to offer to secure the loan.
To make matters worse, state-owned carriers have been receiving government capital injections since 2008 (4.5 billion yuan for China Southern, 9 billion yuan for China Eastern, and 1.5 billion yuan for Air China). Local governments have also provided generous financial support to their own airlines. China's private airlines, which get nothing, are left to face a distorted market.
Moreover, aircraft acquisitions in China still need government approval and Chinese airlines, buying most of their aircraft from overseas, face additional import and value-added tax costs which range from 5% to nearly 23% respectively. VAT for imported aviation supplies is 17% and leasing aircraft from overseas markets also demands a withholding income tax, which totals 7-10% of the lease payment. These restrictive rules on aircraft purchase, coupled with high taxes, significantly increase aircraft costs for China's private airlines, limiting their ability to reach an optimal fleet size.
Although China is starting to relax its policies regarding route permits, these are still largely state-controlled, especially when it comes to major airport access. And China has flight volume controls on its top 10 airports, making it difficult for private airlines to obtain route permits and slots. The issue is further complicated by a policy which forbids the trading, transfer and exchange of slots and routes, making it nearly impossible for China's private airlines to enter these lucrative routes.
At the same time, there are not enough smaller airports to help start-ups realise fast growth. Airport fees are also government-regulated, so these airports lack the flexibility to offer attractive conditions and fees, further preventing private airlines from opening new routes into secondary airports.
SCARCE RESOURCE
Pilots are a scarce resource in China. As a result of the booming economy, the country's civil aircraft total reached 1,259 in 2008, 51% up on 2005, far exceeding the rate at which China can train pilots. Pilots in China are also bound by contracts to work only for airlines that paid for their expensive studies and training. The emergence of private airlines has further intensified this resource problem.
In the absence of any other source, private airlines have to lure pilots from state-owned carriers by offering them attractive salaries, resulting in high costs and frequent labour disputes. And, while the CAAC introduced new rules in 2005, ordering compensation fees of 700,000-2.1 million yuan to be paid to original employers for a pilot to job hop, it did little to address the root of the pilot shortage problem. Pilots are still largely seen as the property of individual airlines. China's private airlines will continue to face a dilemma in a highly restrictive pilot market.
On top of these factors, private players also face a headache because jet fuel is monopolised. China National Aviation Fuel, controlling over 90% of the supply in mainland China, is often blamed for burdening domestic airlines with disproportionately high fuel costs. Private airlines also get different treatment from CNAF's filling stations in more than 140 airports nationwide, which impose much stricter payment requirements on them than they do on state-owned carriers.
For example, in July 2007, CNAF's Shi Jia Zhuang airport filling station refused to provide fuel to United Eagle because of previously unsettled payments, resulting in 241 passengers being stranded at the airport. Similar things happened to other private airlines, which put their operations and reputations at great disadvantage.
Such policy barriers have severely hampered private airlines' ability to grow. Without the essential resources needed to enter new markets and stimulate new demand, revenue suffers. At the same time, these barriers have created tremendous costs for private airlines, further stretching their already fragile cost structure. And, to make things worse, many of these new entrants have suffered from their own weaknesses, in terms of business strategies and management.
PRIVATE FLAWS
A lack of a clear market positioning is probably the most common flaw among China's private airlines. The unprecedented enthusiasm in starting airlines immediately after the new rules entered force in 2005 is tinged with some blindness. Many of these pioneers may not have been fully aware of the capital requirements, costs and risks associated with this industry. Therefore they failed to work out a feasible business plan, with a clear market positioning towards long-term development. Okay Airways, for example, has been pursuing development in cargo and passenger markets, making it impossible to concentrate its limited resources on either.
Management problems have unsettled several of China's private airlines. Okay's two-month flight suspension in 2008 was the direct result of an internal dispute among its shareholders. Complicated ownership structures are not rare among China's private airlines, primarily driven by the quest for badly needed capital. The shareholders of United Eagle and East Star have changed frequently over the past five years, making it difficult for them to have a consistent leadership for their main business.
Against the backdrop of this gloomy battle ground, Spring Airlines, with its 158 million yuan profit in 2009, is a rare bright spot. The airline, established by its own successful travel agent, has clearly positioned itself as China's "number one budget airline". There has been no shift in this positioning, even when the airline was fined by Chinese regulators for selling tickets priced at 1 yuan. It also benefits from a simple ownership and cost structure, allowing it to effectively implement its strategy.
Spring's success should be treated with cautious optimism. The airline, also confined by the unfavourable policy environment, is small both in scale and market share, making it vulnerable to market changes. But it is now set to expand into the international market after securing new route approvals.
COMPLEXITY COST
Dealing with this fresh complexity, while maintaining its low-cost structure, may be a challenge. It also needs to be alert to the activities of the New China Eastern, a government-promoted merger between China Eastern and Shanghai Airlines, in its Shanghai home base. With a combined 50% market share in the Shanghai area, the new state-owned carrier will soon bring competition to a higher level.
Last year saw closer ties between state-owned and private airlines in China. United Eagle received a 200 million yuan capital injection from Sichuan Airlines, becoming the first private airline acquired by its state-owned competitor. Tianjin-based Okay Airways has been in talks with the Tianjin government for a similar co-operation. Some analysts have even speculated this "de-privatisation" phenomenon might lead to a trend where China's private airlines could be completely wiped out.
It is fair to say that the state of China's private airlines, although partially caused by their own weaknesses, is primarily due to regulatory constraints. Remember, deregulation is still new to China's civil aviation industry. Five years ago it took great determination for the Chinese government to open the market, but it will take even greater determination to remove regulatory constraints which have restricted the industry for half a century.
Lively competition is needed to encourage state-owned carriers to rationalise their business structures, cut costs and improve efficiency. But to achieve this, private airlines need policy support, such as multiple sources of capital, or preferential policies in route development, to tide them through the initial development phase.
Many successful airlines globally have benefited from government support in their early days. Southwest Airlines, for example, relied largely on favourable rulings from courts to survive hostile competition in its early difficult years. Similarly, if it were not for a government decision in 1989 which granted Ryanair the sole carrier licence to protect it from predation on certain routes, the then money-losing airline may have left the industry 20 years ago.
Over the past five years, China's private airlines have been flying with extremely heavy wings. Some even doubt if there is any future for them in China, and the country will need to further open its civil aviation market to become a more integrated part of the world economy.
But the past five years have seen China's major carriers join global airline alliances, more foreign airlines flying to China, more approved destination statuses granted - including those to Canada and the USA - and the signing of a China-USA Open Skies agreement in 2007. These and many other encouraging signs have increasingly challenged the country's restrictive civil aviation policies, calling for a liberalised market. Private airlines, a natural product of liberalisation, will sooner or later find their position in China's aviation industry. It is more a question of "when", rather than "if".
PATIENCE PAYS
Some encouraging trends are already in sight to give hope to those waiting for a change. Firstly, demand for air travel in China has, and is, expected to grow rapidly (see chart, left), bouncing back last year after the 2008 blip when the earthquake and flight restrictions imposed around the Beijing Olympics curtailed passenger growth. With a 1.3 billion population and booming economy, China is to become the world's second largest aviation market.
In comparison with the USA, where the average American flies four times a year, only 17% of China's population took an air trip in 2009, leaving a huge gap to be filled. Recently, China has seen more rural residents, accounting for 54% of the total population, travel by air. With an average annual income of less than 5,000 yuan per person, they represent huge potential for the low-cost sector, which will sooner or later benefit private airlines.
Secondly, according to CAAC's National Civil Airport Development Plan released in 2007, China will add 97 more airports by 2020 to reach 244. Notably 43 of the new airports are set for completion this year. The short-term goal is to give 78% of the nation's population access to an airport within 1.5 hours driving distance by 2010 (now 61%), and the long-term goal will see this figure increase to 82% by 2020. The acceleration of airport development in China, especially in the first three years of the plan, can help private airlines stimulate travel demand outside major cities, providing them opportunities for regional development.
Thirdly, the Big Three have been making great efforts since 2009 to strengthen their hubs for forthcoming international expansion. Currently, most of their routes and capacities are tied to domestic market, resulting in over-capacity problems, fierce competition and fare wars. Feeling increasing pressure, especially with the recent challenge of high-speed rail, the Big Three have started looking at the international market where they enjoy a massive advantage over smaller airlines. The repositioning of the Big Three to shift more capacity to international long-haul routes is likely to open up new opportunities for private airlines.
AIRCRAFT CHOICES
Finally, China's ability to build commercial aircraft will provide its airlines with more affordable options. The ARJ21, the home-made medium and short-range regional jet, is set for delivery next year. And China's recent plan to build large commercial aircraft, the Comac C919, within six years is well-timed.
According to Boeing's latest global market forecast, China will need to buy 3,770 new aircraft in the next 20 years. For China's private airlines, domestically-built aircraft would reduce the financial burden of aircraft purchases, maintenance and crew training.
As the old Chinese saying goes, the combination of the right time, right place and right people make a successful business. As one of the fastest growing economies with huge air travel potential, China is undoubtedly the right place for private airlines. Given a truly liberalised market environment, the right people have the potential to swing private airlines from a mood of failure to a real success story.
Jane Pan is a Vancouver-based Chinese air transport specialist. She was formerly with Lufthansa and IATA in Beijing, becoming training manager at IATA's China Training Centre in 2001
Source: Airline Business
