"China should...remain an attractive source of growth for the entire region's airlines. However, the domestic Chinese market is plagued with overcapacity and price pressure," Merrill Lynch said in a research note.
The brokerage said that it expects China's air passenger market to grow 10% to 13% annually over the next five years, slightly slower than an average 15.4% over the last 15 years, but still enough to drive the regional market.
China's 15.4% growth rate compares to a 7% annual growth of the rest of the Asia-Pacific region for 1990 to 1995.
Rising disposable incomes and a progressive relaxation of travel restrictions have made leisure traffic an increasing driver of growth on domestic and international markets, although two-thirds of passengers on Chinese airlines fly for business purposes, Merrill Lynch said.
In the first eight months of 2005, international passenger volumes on China's airlines were up 15.5% from the previous year, while domestic volumes, which accounted for 88 pct of passengers carried, rose 11%.
Merrill Lynch said it expects the strong growth in the international segment to continue over the next few years.
"As a result, strong growth in international Chinese traffic (both inbound and outbound) should support traffic growth volumes throughout the region," the brokerage said.
China's airlines account for around 20% of all passenger traffic carried by Asia's airlines, Merrill Lynch added.
China's cargo traffic has also shown strong growth, averaging 17% annually since 1990, but government policy favoring the development of passenger business has left the country's airlines lagging behind others in the region.
China's airlines account for only 10 pct of cargo traffic carried by Asia's airlines, with the majority of the country's exports by air transported by other carriers in the region, such as Cathay Pacific, China Airlines, and Korean Air, or by airlines from other parts of the world, Merrill Lynch said.
The three main airlines in China -- Air China, China Southern, and China Eastern -- all intend to add dedicated freighters to their fleets over the next three years, while new cargo carriers are also planned, including Shenzhen Airlines-backed Jade Cargo, Great Wall Airlines and Yangtze River Express, the brokerage added.
"For air cargo, we forecast average annual growth of 15% as China's airlines begin to increase their focus on the cargo segment," it said.
China's domestic market is showing significant signs of overcapacity, with both China Southern and China Eastern reporting a decline in passenger yields for the first half of this year, Merrill Lynch said.
All three of China's main airlines also had seat load factors below the sector average of almost 75%, the brokerage said.
"We believe that this indicates that there is substantial spare capacity in the system, particularly outside the peak summer and holiday periods."
Earnings for Air China, China Southern and China Eastern are expected to decline this year on the back of the weak domestic pricing environment and surging fuel costs, which will be partially, but not totally, offset by the imposition of fuel surcharges on domestic tickets from August 1, Merrill Lynch added.
"We fear price competition may mean that airlines end up surrendering a substantial proportion of the extra fuel surcharge income from lowering underlying fares," the brokerage said.
Air China is the only major Chinese airline likely to report a full-year profit for 2005, while China Southern and China Eastern will remain loss-making in 2006 if fuel prices remain at current levels, Merrill Lynch said.
The brokerage added that, among airlines in the Asia-Pacific region, it favors AirAsia, Cathay Pacific, China Airlines and EVA Airways, while it has "sell" recommendations on both China Southern and China Eastern.
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