17-Jan-2013 7:30 PM

China-Japan traffic bottoms out but faces massive challenge; Spring Airlines to launch new routes

Analysis

Several political actions sparked extreme anti-Japan sentiment in Sep-2012 that saw the air traffic market between the two nations lose nine years of growth as 31%, or 175,000 monthly seats, were taken out of the market. The situation lasted longer and more profoundly than airlines initially expected as they planned for about half of the lost market to rebound by the end of 2012.

Instead, that may not occur until the middle of 2013 at the earliest. Since capacity fell in Nov-2012, the market has regained 1ppt of the lost traffic, indicating a likely bottoming out. Yet further effects have expanded beyond mainland China, slightly impacting Hong Kong-Japan traffic as well.

So it is all the more significant that China's only LCC, Spring Airlines, is planning a fairly aggressive growth campaign for mid-2013 between China and Japan, opening new cities on either end, including the under-served secondary cities that have much growth to be unlocked.

Summary

The China-Japan air traffic market lost nine years of growth in 2012 due to extreme anti-Japan sentiment sparked by political actions.
The market has gradually recovered since then, but it may not fully rebound until mid-2013.
China's only LCC, Spring Airlines, is planning an aggressive growth campaign for mid-2013 between China and Japan, opening new cities on either end.
The Chinese government's portrayal of relations with Japan as normal is crucial for airlines to regain their positions.
Air China and China Southern made the largest capacity cuts in the China-Japan market, while ANA and JAL were less reactive.
Spring Airlines' expansion plans in Japan indicate the untapped potential in the China-Japan market, but government support is needed for a quick recovery.

Spring's moves, still pending, are a pointer to what the true potential is in these until now sleepy markets. But without a dedicated effort from the Chinese government to portray relations with Japan as normal, airlines will face a long battle to regain their positions.

China-Japan market has likely bottomed out

The market between China and Japan was affected by a Sep-2012 dispute concerning a series of islands in the East China Sea called Diaoyu in Chinese and Senkaku in Japanese. While ownership has long been contested, the matter flared up on 11-Sep-2012 when, in pre-election mode, Japan nationalised the islands by purchasing them from the current Japanese landowners. Japan contended it wanted to preempt the at times defiant local Tokyo government from purchasing and administering the islands, which Tokyo has spoken of doing.

Japan hoped that national control would limit development and ensure a low profile for the islands - but it had exactly the opposite effect. China issued stern warnings and even, in a rare move, tolerated multiple and huge demonstrations against Japan across China. (Some later contended this was less about anti-Japanese sentiment than some political factions sanctioning the protests in a show of force to rival groups just as final negotiations were taking place for China's once-a-decade leader transition.) Violence against individuals and companies were reported in China, while the situation in Japan was far calmer.

Airline reactions were swift, in part out of seeing the market seemingly evaporate: All Nippon Airways says in the days after the flare-up that cancellations outnumbered new bookings. As CAPA previously wrote:

All Nippon Airways as of 18-Sep-2012 has seen 18,800 tickets cancelled for travel from September to November, the carrier told the Wall Street Journal. Some 3,800 were from Japan-originating passengers while the remaining 15,000 were from China-originating passengers. The total cancellation rate represents 5% to 8% of available scheduled capacity, according to CAPA's Innovata database.

Japan Airlines, amongst others, is treating the delicately named "Japan/China situation" as equivalent to a force majeur and waiving ticket cancellation and change fees for flights until 19-Oct-2012. Citing "recent irregular changes in travel demand", JAL on 21-Sep-2012 announced reductions on Japan-China flights from 10-Oct-2012 to 27-Oct-2012. Tokyo Narita-Beijing and Osaka Kansai-Shanghai Pudong will be reduced from two daily to one daily services while Tokyo Narita-Shanghai Pudong will be decreased from three daily to two daily services. This represents a 22% decrease in capacity in the China-Japan market for JAL.

Far greater proportional consequences are anticipated from Spring Airlines, which primarily carries Chinese tourists on its small but growing Japanese network and expects a 30-40% traffic decline in the short-term as a result of the dispute. Spring says 120 of 400 passengers booked to travel on the carrier until China's National Day Holiday in Oct-2012 have cancelled their bookings. Spring has cancelled its planned 10 charters to Tottori (but no other destinations). The Tottori services were only finalised in late Aug-2012, giving them little time to spool up and acquire bookings, unlike other Japanese destinations on Spring's network.

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Service cancellations and down-gauges were initially for only a few weeks but were gradually extended. The 520,000 seats on offer in Sep-2012 declined to 382,000 in Nov-2012. Dec-2012 saw a small uptick to 399,000 seats. In Oct-2012 carriers had forecast a faster rebound, scheduling about 500,000 seats in Dec-2012, which ended up seeing only 80% of the capacity initially scheduled.

The Dec-2012 uptick continued with Jan-2013 seeing 411,000 seats. Airlines have become less bullish of a near rebound as they schedule service cancellations further out. Feb-2013 will see 388,000 seats - a worrying trend: despite February's shorter length to other months, February is host to Chinese New Year, a peak travelling period. Mar-2013 capacity continues the very gradual growth, with 437,000 seats. If the Mar-2013 figure is realised, capacity will still be down 22% from Aug-2012, right before the flare-up.

China-Japan monthly seat capacity: Jan-2003 to Mar-2012

Air China and China Southern made biggest cuts

Capacity decreases have not been equal across all airlines, which between the two countries number a dozen, although five carriers - Air China, ANA, China Eastern, China Southern and JAL - controlled about 91% of the market in Aug-2012 prior to the Sep-2012 flare-up.

Japan-China market share by airline based on seats: 20-Aug-2012 to 26-Aug-2012

Of the five main carriers in the market, Air China and China Southern made the largest cuts, dropping capacity 30-35% in Oct-2012 and then in Nov-2012 about 15% for Air China and 30% for China Southern. ANA has been less reactive, recording almost no capacity cuts in Oct-2012 despite competitors dropping capacity by at least 5%. JAL in Oct-2012 was in the middle of the pack before growing the fastest (from a low base) in Dec-2012 but then dropping capacity the most in Feb-2013.

The China-Japan market sees different traffic flows from each side's airlines. The Japanese side has more pronounced Japan-originating business traffic, and those passengers typically fly on Japanese carriers as affinity to national carriers is very high in Japan. The Chinese side is more leisure-oriented, and Chinese carriers capture that leisure traffic as well as Japanese passengers looking for lower fares, which the Chinese carriers typically provide.

The Japanese carriers have been shy to make large replacements of widebody service between key cities with narrowbody service - possibly to preserve the widebody experience the business market prefers; significantly, ANA's early statistic was that of the 18,800 cancellations it received in the first week after the Sep-2012 flare-up, 15,000 - or 80% - were from China-originating passengers.

ANA in late Oct-2012 said business traffic was recovering but leisure and package demand was still low. At the time ANA equated the situation with forward bookings as similar to the Sep-2010 collision between Chinese and Japanese boats, but the market saw few lingering effects: in the month after the 2010 incident capacity dropped about 4% lower than normal for that time of year, but rebounded in coming months. In the 2012 situation, the drop was sharp and rebound so far weak (provided the slight growth is actually a rebound).

The Chinese carriers have better forecast the situation - or Japanese carriers are intentionally trying to preserve the status quo: JAL's Nov-2012 operating data, the most recent available, indicates the load factor for its Chinese services was 49.9%, down from the 65.5% load factor recorded a year prior. That was even worse than Sep-2012 (load factor of 61.5%) and Oct-2012 (load factor of 51.5%).

ANA does not report monthly performance by region, but ANA's load factor for all international services has declined from high 70% between May-2012 and Sep-2012 to low 70% in Oct-2012 and Nov-2012. These figures are significantly higher than those in 2011 when Japan was still reeling from the Mar-2011 earthquake and tsunami. The dip in the low season, however, was smaller in 2011. The 2012 dip is correlated to the Chinese situation: ANA said that after limited down-gauging on its Beijing services, load factors recovered by 15-20%. Chinese carriers do not regularly announce monthly performance.

Carriers are projecting growth in Mar-2013, but it remains to be seen if this will be realised. Even if it does, there is still a long way to go to restore traffic to pre-crisis levels.

Select Chinese and Japanese carriers' month-on-month capacity growth between China and Japan: Feb-2012 to Mar-2013

Restoring the Japan-China market quickly will require government support

ANA has given some of the clearest insights into the effect the situation is having. The carrier had forecast about a 20% year-on-year increase in passengers carried between Japan and China in the second half of FY2012, ending on 31-Mar-2013.

ANA's capacity in Oct-2012 ended up being up 11% year-on-year, even with limited capacity reductions. Without the flare-up and capacity reduction, and rallying of load factor, ANA would have likely achieved its 20% target.

On 31-Oct-2012 ANA said its new projection for 2H2012 was a 20% drop in passengers for 3Q2012 year-on-year (equating to a one-third decline from the original target), with the figure slowly rebounding to near the original target by the end of 4Q2012. ANA's forward capacity projections for Feb-2013 and Mar-2013 now no longer support such a fast rebound: Feb-2013 capacity will be down 15% and Mar-2013 down 9%.

ANA comparison of planned values for Chinese routes (passenger numbers) for original (pre-Sep-2012) plan and revised (Oct-2012) plan

The revised plan would have seen a JPY10 billion (USD112 million) revenue decrease. In FY2011 ANA reported approximately JPY81 billion (USD907 million) of revenue from China, a depressed figure, again owing to the Mar-2011 earthquake and tsunami. But with ANA reporting in FY2011 JPY971.5 billion (USD10.8 billion) total passenger revenue, the China flare-up will overall likely have a small effect. ANA's revised China forecast in Oct-2012 was cushioned with the announcement that overall operating expenses were being revised downward, with net profit projected to remain the same, off-setting any impact from the China situation.

While figures from Chinese carriers are less forthcoming, they will probably be harder hit as the China-Japan market, especially for Air China and China Eastern, is one of their more profitable ones, whereas ANA and JAL have more profitable markets elsewhere to fall back on. China's state-owned carriers then find themselves in the delicate position of giving way to Beijing's larger political plans, while wanting the government to encourage a travel rebound. There is also growing concern from the financial community that the withdrawal of the Chinese carriers' capacity is being re-allocated to the domestic market ahead of demand - this in a market which has been further weakened by a slowing economy.

With the dispute four months in and growth being marginal to flat despite a recent relative silence from the Chinese press about the Japanese situation, it does seem that pro-Japan news - borderline propaganda - may be needed to kickstart growth from the Chinese side, which has seen the larger fall. While dissidents and free-thinkers in China capture international attention, Beijing still wields significant influence over the daily life of most Chinese.

A clear message from Beijing that the situation is past and relations normalised, with all associated implications for travel, would do wonders for the China-Japan market. But the situation is heavily political and air transport impacts will likely not budge far larger, symbolically at least, perceived impacts of loss of face, or political goals. This will be a setback for a market that just prior to its stunting showed signs for rapid growth.

Korea-China markets grew 58% following open skies agreement and now huge potential for Japan

With exceptions, the China-Japan market has been fairly consistent with seat capacity in recent years. This is unlike the South Korea-China market, which sees large fluctuations. But this is a sign of health: Korea and China reached a limited open skies agreement in 2006, which produced 58% growth between the two countries within a year. The open skies agreement excluded key cities like Beijing and Shanghai but covered the Chinese provinces of Hainan and Shandong, both big leisure destinations, which naturally produce demand variance.

Even in winter, approximately 18% of scheduled seats are to or from Shandong province, which includes the cities of Qingdao, Weihai and Yantai, all mere hundreds of kilometres from Korea, leading to large traffic flows, unlike to Hainan, about 2,500km away from Korea. It is seats to and from Shandong that see large variance, and are reflected in the larger Korea-China traffic flows.

South Korea-China monthly seat capacity: Jan-2003 to Mar-2013

This level of growth was poised to be realised for China and Japan, which agreed to an open skies arrangement in Aug-2012, mere weeks before the Sep-2012 deterioration in relations. While the China-Japan open skies did not immediately include significantly expanded service to main cities on each side (owing to slot restrictions), it opened the door for an explosion in service from secondary cities. Some 69% of seats from Japan to China currently go to either the city of Beijing or Shanghai. AirAsia Japan, one of three LCCs that launched in Japan in 2012, saw this opportunity as large, but timelines no doubt are being re-considered in light of the situation.

Prior to the open skies agreement, Korea-China capacity, with 300,000-400,000 monthly seats, had been treading below Japan with 400,000-500,000 seats.

But after the Korea-China open skies agreement, Korea-China capacity soared to 700,000 monthly seats. While there was a decrease during the 2008 economic downturn, capacity in late 2012 was back up to around 700,000. But Japan-China capacity has briefly peaked to only 600,000 monthly seats despite Japan being larger than Korea in terms of capacity and GDP: 128 million people to Korea's 50 million, and USD5.87 trillion GDP to Korea's USD1.12 trillion.

South Korea is mainland China's second largest origin of seats after Hong Kong. With open skies between China and Japan, the latter would have begun to overtake South Korea. But the timeline on this will now be delayed.

China top 10 international arriving seats by country: 14-Jan-2013 to 20-Jan-2013

Hong Kong, also feeling anti-Japan sentiment, sees smaller capacity decrease

Elsewhere in North Asia, capacity is normalised, lending credence to the belief it is this political dispute and not other trends affecting capacity. The China-Korea and Korea-Japan markets are each performing normally.

Hong Kong, however, has seen some of its population - different in outlook from mainland China, but not entirely - share mainland China's response to Japan over the situation. That led Hong Kong Airlines to cancel its daily Hong Kong-Tokyo Narita service on 737-800s, taking out about 4,500 monthly seats, but this in a market with 194,000 monthly seats.

Even before the dispute however, traffic has been low, but the mood from carriers was to maintain capacity in order to leave their networks intact so as not to alienate passengers wanting reliability. However, the dominant player, Cathay Pacific, did make one-off cancellations to flights exceptionally unprofitable. Hong Kong Airlines was generally more O&D focused, and thus exposed to local sentiment from Hong Kong, whereas Cathay has large transfer passenger business that, outside of mainland China, would not be impacted by China-Japan relations.

Hong Kong to Japan (seats per week, one way): 19-Sep-2011 to 07-Jul-2013

Spring Airlines to open services from China to Osaka Kansai and Sapporo

Despite the generally negative outlook, there is one uplifting note, and a relatively big one at that: Spring Airlines, China's only LCC, is planning an aggressive expansion of China-Japan services in 1H2013.

The carrier currently serves three Japanese cities: Ibaraki (an alternative to Tokyo), Saga (alternative to Fukuoka) and Takamatsu, each from the carrier's base at Shanghai Pudong. Spring's first Japanese service, to Ibaraki, started in Jul-2010. Plans to serve Tottori were put on hold after the China-Japan relation flare-up.

Spring's selection of these second and third-tier airports was largely impacted by route restrictions - incumbent Chinese carriers have been known to heavily lobby against additional competition - although the airports do offer the carrier cost savings. Spring has expressed hopes of one day being allowed to serve Tokyo Narita on its Chinese AOC.

The carrier will likely base its proposed Japanese joint venture at Narita.

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Local reports indicate all-A320 operator Spring will launch four new routes: Shanghai Pudong to Sapporo as well as from Shenyang, Tianjin and Wuhan to Osaka Kansai. Shanghai-Sapporo will be Spring's first service into Sapporo while making the route Spring's fourth Japanese one from Shanghai. Shenyang, Tianjin and Wuhan have yet to see international service from Spring.

The terminating point in Japan of Osaka Kansai will also be new to Spring.

Service is reportedly likely to be three or four times weekly and likely will start off as a charter programme. The routes were reportedly due to start in Jan-2013, but that date was pushed back due to the China-Japan situation. The new launch may be as early as Feb-2013 and late as Apr-2013.

Competition summary on Spring Airlines' proposed new routes to Japan: 15-Jan-2013

Spring's proposed routes	Passenger Competition from other airlines
Shanghai Pudong-Sapporo	Only services from Sapporo to China are twice-weekly Air China 737 service to Beijing and thrice-weekly China Eastern A319 service to Shanghai Pudong.
Shenyang-Osaka Kansai	China Southern has two weekly A319 flights on the route. Only other service from Shenyang to Japan is daily ANA 737 flight and thrice-weekly China Southern A319 service
Tianjin-Osaka Kansai	No direct competition. Tianjin's only service to Japan is daily JAL 737 service to Nagoya
Wuhan-Osaka Kansai	Wuhan has no service to Japan

Spring will take competitors head on between Shanghai and Sapporo and Shenyang and Osaka, but direct competition may be limited (depending on operating days) as incumbents operate less than daily.

Shenyang, the economic centre of northeast China, is a hub for Spring and the carrier's fourth-largest base/hub.

Spring Airlines top 10 hubs/bases/stations by system seats: 14-Jan-2013 to 20-Jan-2013

Wuhan is in central China and a destination in its own right while Tianjin, 125km from Beijing Capital Airport, is viewed mainly as an alternative to slot-restricted Beijing with limited local demand. There is a high-speed train between Tianjin and Beijing, among other transport options. Internationally, Scoot launched Tianjin in 2012 while AirAsia X in 2012 switched its Tianjin service to Beijing, citing better demand despite inconvenient slots.

Spring expects half of the passengers to be Chinese tourists with the remaining half Chinese corporate travellers and all Japanese passengers. For its presence in Japan, Spring will need to find the balance between commercial necessity and local sensitivity. A marketing initiative from Spring in the immediate aftermath of anti-Japan protests saw the carrier offer exceptional sales for its Japanese routes. This backfired when social media users announced outrage at what they saw as Spring not shunning Japan. But with initial services on the new routes to be on a charter basis, Spring can rely on partners.

Japan on the cusp of realising how big the potential China-Japan market is, even with spats

Japan may be experiencing the worst aviation-related repercussions of countries that have offended China, but the Japanese experience is a reminder the Chinese market is the largest one with its own significant nuances: rules are hardly set in stone, influence and lobbying can be high and the division between aviation and politics is not always discernible.

The rewards can be high, but so too are challenges. Around 5% of all seats offered to, from or within Japan had a Chinese city at one end (the figure is higher for only international seats to and from Japan; about two-thirds of Japanese capacity is domestic).

That share was set to rise with the open skies agreement, reached mere weeks before tensions flared up. It is not gone forever; traffic will return and then grow, as Spring is showing. It is this long-term view of growth the airlines, like peers in less serious situations, are focusing on as they take the situation as it comes, remaining calm and not publicly aggravating to make the situation worse.

The level of unexploited China-Japan city pair markets is about to be highlighted by Spring, which, as the first mover Chinese LCC, stands not just to prove the market, but to exploit it effectively. Aside from the fact that so many potentially large city pairs are unserved, the advantage is that with an open skies regime for regional cities (where airport capacity is typically available, especially in Japan with its plethora of pork-barrel airports) there is almost no hindrance to airlines making their own commercial judgments about where to fly, how often and at what price.

The sky is the limit for these markets; hopefully the seas, and their disputed ownership, will not get in the way.