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Chinese airlines' sixth freedom roles could challenge Middle East, Asian, European hubs this decade

26th January, 2012

Signs are now emerging of the enormous – and largely unanticipated – impact that China’s airline industry will have on the international network as this decade rolls out. It will significantly tilt the world airline system.

China’s airlines have expanded remarkably since 2000, but most of that growth has been in the domestic arena, responding to the country’s rapid economic rise. It is only more recently that the airlines, with Central Government encouragement, have begun to focus more on international routes.

There are obstacles to be overcome. Service quality is typically not at the standards expected of the Asia Pacific region carriers; marketing and distribution remains a problem; yield management systems have been inadequate; and limited networks still make achievement of critical mass a challenge.

Yet Chinese airlines have two great advantages when it comes to operating sixth freedom network roles: they have a massive and growing third and fourth freedom market; and they are geographically strategically placed to service traffic flows from all countries to the south, connecting with North America and Western Europe using the effective north Polar routing. Additionally, they have relatively low cost bases.

China's airlines are taking their first steps to adopt classic sixth freedom network roles

The next steps towards becoming full-fledged network airlines are now being tentatively taken. Partnering with and learning from airlines like KLM, which cast the mould, as well as Cathay Pacific, one of the world’s most successful network operators, is a vital step. But beyond that, forming a suitable route structure with adequate frequency and connections is something that takes time and large scale investment. Meanwhile, those first steps are already destabilising pricing in the markets they serve.

To become a reckoning force in sixth freedom traffic, what the Chinese carriers need – led by the "big three": Air China, China Eastern and China Southern – is not establishment but scale. The carriers are already on their way to building powerful hubs, around what are already thriving domestic centres. And in the geography of ultra-long haul travel, this sets them up to collect and distribute traffic from points anything from three or four to 12 hours distant.

In one example, of the traffic on China Southern's Melbourne-Guangzhou route, 70% of passengers now travel beyond Guangzhou, an admirable figure for any hub. For long-haul traffic Iberia achieves 70% at its Madrid hub, Emirates aims for slightly higher in Dubai and Turkish is around 50%.

More telling is where China Southern's connecting passengers go. Of those connecting, 80% of its connecting passengers go elsewhere in mainland China and 20% make a non-Chinese point their final destinations. That means only 14% of passengers are now stepping off a flight into the world's most populous country and second largest economy – and then leaving. This is only the start. International schedules are still lean by competitive standards, but increasing fast. The only question is how high a priority China's airlines will place on this activity. There can be no question of the validity of the concept.

Massive end-to-end traffic flows support sixth freedom economics

The Chinese sixth freedom strategy can be different from the Gulf airlines' sixth freedom strategy. Gulf carriers, with their small population bases, have relatively limited long-haul origin and destination (third and fourth freedom) traffic to their home countries, forcing Emirates, Etihad and Qatar to use their hubs as connecting points. While Guangzhou, and to a lesser extent Beijing and Shanghai, may rival Abu Dhabi, Doha or Dubai in percent of connecting passengers, China has an enormous and growing home market with hundreds of points best served from within the country.

That gives Chinese carriers a large supply of higher-yielding third and fourth freedom passengers. The remaining seats, with overheads largely already covered, can be cheaply filled with sixth freedom traffic, a balance of which requires careful planning and revenue management. The Chinese approach is not markedly different from the way non-Gulf carriers pursue sixth freedom traffic – except that China's geography offers multiple hubs for optimum connections and the size of the country and its airlines offers scale like never before.

In an early manifestation of this strategy, China Southern is now offering AUD1050 (USD1105) return fares from Australia to Western Europe, half of the normal going rate. In this early stage of Chinese international route development, there is ample scope for cooperation with foreign partners – here notably with KLM. Yet amid this competition, airlines must consider how they will work with the Chinese carriers they seek to partner.

China Southern's airport hubs and schedule banks suit long-haul connections

China Southern has worked to gain scale over the recent season and to boost its transfer traffic figure by adding additional frequencies to destinations including Melbourne and Sydney, the two largest cities in Australia. China Southern envisages being able quickly to dominate two Australian cities before tackling others, an approach used by Emirates and AirAsia X and soon, Singapore Airlines subsidiary Scoot. (Australia and New Zealand have an insatiable demand for international travel while also luring tourists.)

The additional frequencies at Melbourne and Sydney, China Southern said, were strategically added on morning departures from Australia, which arrive in Guangzhou at night, when regional connections dry up but the hub enters full-swing for long-haul departures to Europe and North America. The carrier offers a limited but growing set of long-haul destinations from Guangzhou including Amsterdam, Los Angeles, London, Paris and Vancouver. It also serves Istanbul from its western China hub in Urumqi.

China Southern's smaller hubs at Beijing and Urumqi offer specific geographic advantages: North Asia traffic can be routed over Beijing; subcontinent, Eastern Europe and West Asia traffic can be brought over Urumqi; and Guangzhou can handle traffic to Southeast Asia, Australia and New Zealand. At Guangzhou, the carrier's main long-haul departure bank is in the evening with a smaller one in the morning. In the medium-term the morning bank can be expected to grow, additional banks may be added throughout the day and more emphasis could be placed on Beijing and Urumqi.

The country's longest-standing flag carrier, Air China, is dovetailing with China Southern via its secondary hub in Shenzhen, close to Guangzhou (and a short drive from Hong Kong), as well as a hub in Chengdu in the central part of China. China Southern also has directed attention to central China with a hub to be established at Chongqing. China Eastern has largely pursued strengthening its position in Shanghai but, as its previously shaky financial position stabilises, can also be expected to pursue hub opportunities.

China Southern may expand its A380 fleet, targeting Europe and North America

The short-term promises substantial long-haul growth for China Southern. Two of its five A380s have been delivered but are currently shuttling domestically around China as the carrier waits for approval to serve long-haul routes, possibly out of Beijing, Air China's hub. China Southern could enter the New York market, traditionally Air China's most profitable route. China Southern has hinted that an order for more A380s is likely, but in the interim has 19 widebodies on order for delivery before 2015.

The Guangzhou based airline also has approximately 100 narrowbodies on order, some for replacement but others to expand its regional international network. Frequency will be key and not constrained by airports, which China is amply building and expanding, proof its government understands the critical correlation between aviation and the broader economy, a relationship much to the consternation of those trying to expand London Heathrow or, closer to home, lobby for a third runway at Hong Kong.

See related article: China’s incredible airport growth

China Southern is aiming to expand its international operations from 18.5% of traffic in 2010 to 40% in the medium term. In Australia and New Zealand alone, China Southern plans a fourfold widebody frequency increase by 2015 to 110 weekly services, about 16 per day – similar to Cathay Pacific and Singapore Airlines' levels.

It is not improbable that Australia would see 500 Chinese services weekly by 2020. China Southern's 110 weekly services in 2015 will likely rival those of Emirates, which envisions 100 weekly Australian services in the medium term, continuing the country's title as the carrier's largest single market. Owing to Dubai's greater distance and subsequent need to operate very large aircraft, Emirates may outpace China Southern on capacity, but China will still be at the forefront – especially since the nation's other carriers will join the party.

High-speed rail at home forces airlines to focus on long-haul services

The imperative for China Southern to focus on connecting traffic is greater than for its national competitors. China Southern operates the country's largest domestic network, but expects the country's fast-expanding high-speed rail (HSR) network to impact one-quarter of its domestic network, with potential traffic declines of greater than 50%, echoing the impact – but on a far greater scale – of what European carriers saw after the Channel Tunnel opened. Air China projects a minimal 2-3% impact from HSR while China Eastern has not stated a figure but has said it is in growth mode anyway and can re-deploy capacity.

Air China, which for many years was the mainland's only flag carrier, has the country's largest long-haul route map, serving 11 points in Europe and four in North America. China Eastern serves three points in North America and six in Europe. Air China this year will add its 12th European city, Copenhagen, and is looking at launching its first service to Africa. China Eastern in the short term is focusing on domestic capacity due to global economic conditions.

Of China's smaller carriers, Sichuan Airlines plans in the short term to expand to Australia, Europe and North America. Sichuan's home airport of Chengdu, driven by economic targets, is actively promoting the hub potential that these additions will bring. The capital of Sichuan Province, Chengdu, in 2010 had a population of over 14 million, according to the China Daily.

See related article: Sichuan Airlines expanding network from Chengdu with Australia, Europe & North America routes

Meanwhile, Hainan Airlines last year also expanded its presence in Europe and is now looking to exploit network opportunities. Hainan serves Europe and North America from its Beijing hub but Australia is now served from Shenzhen, where more long-haul growth is envisioned. 

See related article: Profitable Hainan Airlines 'still single'; Driving international expansion organically

Chinese carriers are unlikely individually in the medium term to rival the European route network of carriers like Emirates, which has announced Barcelona as its 30th destination on the continent, but they will have a far wider reach across Asia. But not all are so enthused with the potential.

See related article: China Eastern to shift some international capacity back to the domestic market amid bleak outlook

China's airlines are able to exert pricing power – at drastically lower levels

The build up of mainland carriers' long-haul capacity (and route network) is from a small base, but the carriers are wielding enormous pricing influence. In the Asia-Europe market only one mainland Chinese carrier – Air China – is in the top 10, with China Eastern at #30 and China Southern at #37. Collectively their Asia-Europe traffic is less than Singapore Airlines' traffic.

Top 10 airlines between Asia Pacific and Europe (ranked by seats): 23-Jan-2012 to 29-Jan-2012

Rank Airline Total seats
1 LH Lufthansa 171,766
2 BA British Airways 143,079
3 TG Thai Airways 124,692
4 SQ Singapore Airlines 123,480
5 TK Turkish Airlines 117,856
6 AF Air France 105,944
7 SU Aeroflot 94,118
8 CX Cathay Pacific 88,138
9 CA Air China 78,260
10 UN Transaero Airlines 67,024

Despite their diminutive international status, China Southern and, to a lesser extent, Air China and China Eastern, have driven airfares between Australia and Europe to historical lows for full-service airlines. China Southern this month, fresh from promoting the "Canton Route" as an alternative to the "Kangaroo Route" as well as participating in a number of high-profile events in Australia, is offering return economy fares from Australia to Amsterdam and Paris from less than AUD1100 (USD1152) return, including taxes over a wide booking period.

Prices increase during China's short holidays, when almost the entire country stops business for a week over the Lunar New Year and again in September/October – increasing local demand – but there are only marginal price increases during June and July, popular travel times in Europe and Australia. China Southern's Melbourne-Amsterdam fares, for example, increase by 19-37% in June and July but are still 32% lower than non-Chinese carriers, illustrating how Chinese carriers can use sixth freedom traffic to fill seats when China is not in the midst of national holidays.

China Southern's prices are near-unprecedented levels; competitors' fares around AUD2000 (USD2096) for the route are typically considered very reasonable. Only low-cost long-haul carrier AirAsia X has previously offered similarly low return fares once ancillary fees were considered, but those fares were special promotional fares offered during a limited sale period and required booking months in advance. China Southern's fares by comparison can be booked with short- or long-term notice as part of a sale period stretching across many weeks.

Even more significant than China Southern's fare levels are their market impact. Whereas few carriers responded to AirAsia X's sales, the market has taken notice of China Southern's fares. In a sample of return fares inclusive of taxes between Sydney and Paris, Air China and China Eastern dropped their fares to AUD1500 (USD1577) against China Southern's AUD1100 (USD1152).

Established flag carriers have responded in kind

Qantas and Air France also have dropped their kangaroo route fares to AUD1650 (USD1735) (some of SkyTeam partner Air France's flight options are operated by China Southern). Impressively, United Airlines also put itself in the mix, offering AUD1450 (USD1524) fares for Australia-Europe flights connecting in the United States. United's Australia-US flights by themselves typically price out to above AUD1450 (USD1524).

This yield pressure particularly hits end-of-line carriers like Qantas and Air New Zealand, who use long-haul markets not as backfill but core routes. Qantas already responded to increasing competition on the kangaroo route by deciding last year to end two of its five Asia-Europe routes. Air New Zealand is also now evaluating the frequency it deploys on its sole European route, London Heathrow.

Sample Australia-Europe economy fares for travel in Mar-2012

  Melbourne-Amsterdam Sydney-Paris
Air China n/a AUD1480
Air France n/a AUD1650
China Eastern  n/a AUD1430
China Southern AUD1060  AUD1100
KLM AUD1490 AUD1760
Malaysia Airlines AUD1730 AUD1860
Qantas AUD1730 AUD1650

This discounting trend is less evident in business class fares, where service quality and corporate deals become more relevant. Between Melbourne and Amsterdam, China Southern offers a 19% discount from the next lowest carrier while between Sydney and Paris three Chinese carriers offer the lowest prices. The cheapest Chinese business class fare is 23% lower than the cheapest non-Chinese business class fare.

Sample Australia-Europe business fares for travel in Mar-2012

  Melbourne-Amsterdam Sydney-Paris
Air China n/a USD6360
China Eastern n/a USD5090
China Southern USD5120 USD5130
Emirates USD7690 USD7780
Finnair USD7120 USD7170
Korean Air USD6300 n/a
MAS USD8990 USD6580

The normal discount for connecting versus O&D traffic is evident with Chinese carriers. Melbourne-Guangzhou and Sydney-Guangzhou in economy cost AUD700 (USD734) and AUD800 (USD838) respectively, 66% and 73% of the cost of the tickets to Europe, despite the distance from Australia to Guangzhou only accounting for 45% and 44% of the total journey. Likewise, business class fares from Australia to Guangzhou on China Southern are 72% of the fare to Europe for a fraction of the distance.

These prices are also broadly similar for Europe-originating journeys, which are typically lower than those originating in Australia. Chinese carriers are also undercutting on the Australia-North America route, not to levels seen in Europe but still impressive considering a routing from Australia to North America through China is 50% longer, with associated higher fuel costs, than flying direct. In comparison, flying between Australia and Europe via Guangzhou can be shorter than the traditional Southeast Asia hubs, which are nearly equal in journey distance to the Middle East hubs.

Sample Australia-North America fares for travel in Mar-2012

  Sydney-Vancouver Sydney-Los Angeles
Air Canada USD2150 n/a
Air China n/a USD1460
Air New Zealand USD1780 USD1520
China Eastern USD1380 USD1390
China Southern n/a USD1310
Qantas USD1782 USD1510
Virgin Australia n/a USD1410

One-off pricing can be a shallow survey but it is what drives purchases, reflects competitive standing and, to the undercut airlines, causes agony – and the occasional diplomatic row. A Singapore Airlines (SIA) manager in Nov-2011, before these low fares appeared, told an Australian conference, as reported by Travel Today, that China Southern and other "profit neutral" carriers were undermining SIA's profitability. China Southern, the manager referenced, "is just one airline of many who view the Australian market, somewhat unrealistically, as an abundant utopia of low hanging fruit to the detriment of profit orientated legacy carriers".

Chinese airlines have a significant cost advantage

Although China Southern, with these near-unprecedented fares (similar to levels in the 1970s) is flexing its pubescent muscles to gain awareness, the carrier has a considerable cost advantage.

SIA's CASK ex-fuel is USD9.21 cents whereas China Southern's is USD7.44 cents. The difference is more substantial than might appear. China Southern's figure encompasses a predominantly short-haul network, with a resulting higher cost than the long-haul division. That would place China Southern's long-haul CASK lower than Emirates' at USD7.29 cents.

As China Southern becomes more efficient with newer aircraft, its overall approach can head in the direction of Hainan Airlines, which has a CASK of USD5.82 cents. Those CASKs begin to encroach on the levels achieved by low-cost, long-haul carriers – Jetstar at USD5.07 cents and AirAsia X at USD2.8 cents. But what those carriers lack is the mainland carriers' international network, home advantage for passengers and a hub in Guangzhou, the world's manufacturing centre with plenty of air cargo needs.

Chinese carriers and selected Asia and Middle East carriers unit cost comparison: FY2011

Assuming a long-haul CASK with fuel of around USD6 cents for China Southern, the Melbourne-Amsterdam flights incur a cost of about USD1000 while China Southern's current promotion sees it collect a fare, excluding taxes but including a fuel surcharge, of AUD897 (USD943), allowing China Southern to near break-even without considering cargo. The situation is largely for the same for North American routes.

Japanese and Korean airlines begin to exploit similar opportunities

Meanwhile, Japanese and Korean carriers are also becoming more attuned to the potential market in connecting the south of the region over the North Pole. The two countries' flag airlines, Japan Airlines (JAL)/All Nippon Airways (ANA) and Korean/Asiana respectively, have sought to exploit Chinese connections – and coming liberalisation will increase those opportunities, but their network planners and marketing strategists are finally awakening to the models perfected by the Gulf carriers. This has involved coordinating schedule banks and, even more simply, actually engaging in marketing destination markets.

Japan in particular, now about to embark – at last – on a round of new low-cost airline entry, is fast creating the liberalised access conditions in which new network opportunities can be exploited. Their carriers do not, however, have the same regional traffic O&D volumes, having previously focused their attention, under typically more conservative access regimes, on European and North American markets. But, despite also having higher cost bases than many around them, each country's airlines will be able to exploit their network potential – further challenging the traditional Asian intercontinental hubs for European and American traffic.

International expansion potential makes Chinese airlines even more attractive partners

Depending on the market and city pairs concerned, Chinese carriers have the potential to become at least as influential as the impact Gulf carriers have been. Yet while for now cooperation between Gulf and legacy carriers is limited, Chinese carriers come close to being the holy grail for global alliances. The rush to encourage Chinese partners to join an alliance underscores the huge local market – largely missing with Gulf carriers – that poses tremendous opportunity for foreign carriers. The cause for caution, however, is the prospect of a Chinese partner becoming a competitor, with consistently lower prices.

The attraction of mainland Chinese carriers is natural. Korean Air serves the greatest number of mainland cities, 27, for an international carrier, followed by Asiana and China Airlines at 23 and then Dragonair at 18. Most foreign airlines, even those in close proximity to China, serve only a single-digit number of Chinese cities. In comparison, China Southern serves 110, Air China 91, China Eastern 81 and Xiamen 44.

The country's solitary LCC, Spring Airlines, serves 26 points – more than any foreign carrier except Korean Air. While international carriers will expand their presence in China, mainland carriers will grow at a higher rate. Last year, the Government announced plans to construct 45 airports in five years and no foreign airline will have the ability to compete on those terms.

Sample of number of mainland Chinese cities served by foreign carriers for scheduled flights: Jan-2012

Airline Number of cities served
ANA 10
Asiana 23
British Airways 2
China Airlines 23
Dragonair 18
Emirates 3
Etihad 2
Finnair 2
JAL 6
Korean Air 27
Lufthansa 6
Qatar 4
Singapore Airlines 3
Thai Airways 6

SkyTeam and Star Alliance are well positioned in China, with SkyTeam claiming China Eastern, China Southern and Xiamen while Star has Air China. Noticeably absent is oneworld, which has no mainland member. Willie Walsh, CEO of International Airlines Group, which owns British Airways and Iberia, has openly spoken of the need for oneworld to have a mainland member as well as holding meetings with potential carriers.

Cathay Pacific remains resolute that it and wholly-owned subsidiary Dragonair can fulfil the alliance's needs and that it would not welcome a mainland carrier in oneworld. Mr Walsh and other CEOs, however, clearly see that Dragonair's 18 mainland destinations cannot compete with mainland carriers serving upwards of six times that amount. The culmination of the conflicting views between Cathay and apparently the rest of oneworld could be high-profile if Cathay joins its 30% owner Air China in Star Alliance, although Cathay has always taken a hands-off approach to alliances.

For mainland carriers in alliances, questions loom over how to form closer relationships. In the discounted Australia-Europe fares offered by China Southern, displaced was Air France, a SkyTeam member with China Southern. Some of Air France's coded flights were operated by China Southern but priced higher than those of China Southern. As Chinese carriers become more aggressive in pricing, their partners will need to closely examine commercial relationships, such as whether to pursue block space or free sale codeshares and potential for expanding into a revenue sharing relationship.

As networks grow, the market ripples rapidly spread more widely

The price cuts already underway by Chinese carriers from Australia to Europe and North America illustrate what structural competitive and pricing shifts can occur in other markets, when Chinese carriers turn their attention to them. For the time being, a shortage of network destinations and frequencies limits their market power in neighbouring markets, whose airlines have established large sixth freedom operations over the years. But, with the advantage of abbreviated access to Europe and America over the North Pole, and as their route structures grow, so their catchments will expand.

Even competing with non-stop services, the potential pricing differentials will guarantee the Chinese airlines substantial market shares, once routes and frequencies are in place – underpinned by large third and fourth freedom flows.

This scenario will progressively unfold over coming years. What is most surprising is how fast the recent evolution has occurred, since China's Minister exhorted airlines to "go international" only two years ago. The network and traffic base is still low, but we have now had a taste of the possible and how fast it can become reality.

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