China is pushing ahead with sweeping changes to the airline industry that will lead to the creation of three big groups. However, not all the participants in the process are happy about their prospective partners. There is good and bad news for China’s big birds. On the positive side, Chinese airlines will grow bigger and stronger, thanks to a governmentled merger and acquisition spree and projected strong passenger growth at home in the next few years. The consolidation plan, announced last April, is proceeding with difficulty but will not derail the creation of three major airline groups that will account for 80 per cent of the domestic market.
The bad news is that airlines across the world have suffered from a sharp downturn in business because of the September 11 attacks and the global gloom that followed. According to the chairman of China Eastern Airlines, the attacks will cost China’s three biggest airlines Yn3.35bn in losses in 2001 and 2002. Even before this, Chinese carriers were struggling with high fuel costs, excess capacity and cut-throat price competition. The country’s 30 airlines operate in a highly fragmented market, serving 1,100 routes with more than 500 planes. In the first half of 2001, the industry incurred a loss of Yn2bn, compared with profits of Yn850m for the whole of 2000.
The Civil Administration Authority of China (CAAC), both majority owner and regulator of the industry, quickly imposed price controls in mid-2001 and the industry turned a profit of Yn1.23bn in July and August as a result. Then terrorism hurt aviation business worldwide and Chinese airlines plunged into the red again. In the week following the September 11 attacks, China’s three biggest airlines and the ones most involved in international business – Air China, China Eastern Airlines and China Southern Airlines – incurred losses of Yn73m from reduced passenger and freight business. The three, with much of their debt in yen, also incurred an estimated loss of Yn220m in foreign exchange due to the temporary strength of the Japanese currency last September.
Then there are the extra insurance premiums and other safety-related costs. From October 1 last year, Chinese airlines have had to pay more than Yn1bn extra a year to insurers in the wake of September 11. In addition, General Electric of the US has asked Chinese airlines to pay US$100m more in insurance to lease 51 of its Boeing planes. The airlines also need to pay US$25m extra to beef up their safety facilities, as required by international regulations.
Chen Xiaoning, CAAC’s research director, expects more economic pains for the industry this year, given the poor prospects for tourism and Sino-American trade. Look beyond the next few months and the future looks much better for several reasons. First is the potential of the domestic market. China is expected to be the world’s second- largest aviation market in two decades’ time, with an annual average growth of 9 per cent. Currently, only 5 per cent of the population fly each year, allowing considerable room for expansion.
That is why CAAC has stuck to its plan to buy 36 Boeing 737 planes this year. Airlines too are busy drawing up new international routes. China Southern is preparing to fly from Guangzhou to Fukuoka and Tokyo, while China Eastern plans to fly more often to the US and Europe. Another reason to be hopeful about the future is CAAC’s ambitious merger-andacquisition plan:
Air China, based in Beijing, is to merge with Chengdu-based China Southwest Airlines in Sichuan, Zhejiang Airlines in Zhejiang and China National Aviation Corporation (CNAC), a Hong Kong-listed company with equity in Dragonair and Air Macau.
China Southern, based in Guangzhou and the largest carrier in China with 110 aircraft and 341 routes, is to merge with China Northern Airlines (based in Dalian in the northeast) and Xinjiang Airlines.
Shanghai-based China Eastern is to merge with Yunnan Airlines, the Ningbo-based Great Wall Airlines and China Northwest, which operates out of Shaanxi province.
After the acquisitions, the three major airlines will have nearly doubled their market share, their fleet sizes and their geographical coverage. Air China will add to its international business a strong domestic penetration, which it currently lacks. China Southern and China Eastern will fly to new inland areas where they have a weak presence.
The big airlines will need to streamline their bloated staff. Air China has announced plans to lay off 2 per cent of its 11,000 workers. Kevin O’Connor, an aviation analyst at Deutsche Bank in Hong Kong, says Chinese airlines are not as overstaffed as they appear. “In terms of capacity per staff member, we estimate that Cathay Pacific and Singapore Airlines are nearly three or four times as efficient as China Southern and China Eastern,” he says. “However, costs per staff member in China are much lower. Also, we have to bear in mind that wide-scale restructuring and redun-dancies could have high social costs. The problem therefore has to be tackled not only by job reductions but also by growth of the industry.”
Marston Lai, aviation analyst at the Hong Kong-based Worldsec Securities, says the mergers will bring relief to the ongoing fare price war. “With fewer players in the consolidated market, we expect the pressure on domestic airfares will be eased,” he says. “We expect the number of players will be further reduced.” Domestic fares have dropped as much as 50 per cent in recent months, with a round trip from Beijing to Shanghai costing only Yn1,000, down from Yn1,800-2,000 one or two years ago.
Regional airlines fight back
Smaller airlines are fighting back. Soon after CAAC announced the mergers, six regional airlines – Shanghai Airlines, Sichuan Airlines, Wuhan Airlines, Shenzhen Airlines and China Postal Airlines – formed an alliance to jointly promote their business. Collectively, they have assets of Yn20bn, 100 planes and 10-12 per cent of the national market. These small airlines tend to be better managed than the major airlines, and the six account for 35 per cent of all profits made by China’s airlines.
Hainan Airlines, one of China’s most profitable carriers, continues to operate as a loner. It has its own acquisition plan. Last July, it bought 89 per cent of Shanxi Airlines, based in the central province of Shanxi, for Yn5m cash and Yn280m of aviation assets. It also plans to acquire 66.9 per cent of the Xian-based Changan Airlines, for a sum of about Yn355m.
CAAC said it had worked on the mergers for a long time, taking into consideration factors such as geographical differences, individual airline strengths and overall competition. Despite its meticulous planning, the mergers have not been smooth sailing. Air China and CNAC are arguing who should lead their new group. Air China is the bigger airline of the two, but CNAC is stronger financially, with billions of yuan of spare cash. “The two parties are waiting for an authoritative outside party to resolve their dispute,” reported the Beijing-based Economic Information Daily in late December.
China Eastern meanwhile is unhappy to merge with China Northwest, whose debtasset ratio stands at 120 per cent, the highest of all China’s airlines. According to Economic Information Daily, the two airlines have stopped discussing the merger. China Eastern wants CAAC to help lobby the banks write off Northwest’s debt before the merger occurs.
China Southern appears to be the happiest of the three groups. “It is the biggest winner [of the merger plan], with the biggest market share eventually of 35-40 per cent, up from the current 24.5 per cent,” says Lai of Worldsec Securities. Wang Changxun, general manager of China Southern, said last August it would take 12-18 months to complete its mergers with the new partners.
With all these problems, CAAC’s ambitious target to complete the mergers within six months looks unrealistic. So far, only China Eastern has completed the acquisition of Great Wall Airlines for Yn400m, comprising an injection of cash and shares from Hainan Airlines. The other airlines are merely assessing the value of their partners’ assets, with no serious merger negotiations have yet taken place. They are co-operating in peripheral areas such as ticketing, warehousing and other on-the-ground services.
The airlines would have moved faster had they been allowed to choose their own partners. China Eastern and Air China wanted to be merged together, while China Southwest and Yunnan Airlines wanted to join China Southern, industry sources say. CAAC, with national rather than regional interests at heart, turned down their applications.
Mergers alone are unlikely to turn China’s money-losing airlines into competitive companies. They need to have a change of ownership, either through listing or transfer of shares into an independent board of directors with genuine management power. CAAC is currently both the industry’s regulator and the major shareholder of the 11 airlines.
As long as the airlines remain under the control and protection of CAAC, they will not behave like genuine commercial entities. They will continue to over-spend and overhire, as state firms have always done. In the 1990s the airlines borrowed heavily to buy planes and open up new routes, regardless of cost efficiency and their wretched finances. That is because the loans provided by state banks are cheap – and can be rolled over indefinitely if the airlines succeed in lobbying the government about their difficulties.
Hu Angang, director of the Beijing-based Centre for China Studies, urges a complete divorce of business ties between CAAC and the airlines. Only then can airlines operate independently, on a purely commercial basis without favours from CAAC. However, he stops short of suggesting a complete privatisation of the airlines.
CAAC has said it will operate as a pure regulator once the mergers are complete, although it has not said what will happen to the stakes it holds in the airlines.
For the moment, there is little external pressure on CAAC to introduce radical ownership reform. China’s entry into the World Trade Organisation, a powerful catalyst of change for other industries, will not affect airlines. The airline industry remains closed under the WTO accord, leaving Chinese airlines to fight among themselves in the increasingly crowded sky.