China may allow LCCs and new entrants in airline sector reforms, but no deregulation for now

This report looks at what some of the changes may be. Some topics will be examined in greater detail in follow-up reports.

New airlines will be permitted to launch, but not in first-tier cities

The big picture agenda for national reforms, some expect, will be supporting the change from predominantly government investment to private capital operating in something of a free market. So it makes sense to unfurl the welcome mat to prospective private carriers. And China has done just that in recent times, gradually increasing its support.

CAAC administrator Li Jiaxiang in Aug-2012 noted that private companies have invested over RMB 60 billion (USD9.4 billion) in Chinese airlines in recent years - higher than state investment - and that the CAAC had recently approved more private carriers than public ones. Mr Li noted private companies could approach the CAAC first or that the CAAC may approach companies first. More recently, the CAAC has directly said private investment is critical for aviation's growth.

Determining the actual current policy for admission of new carriers is difficult. During the last decade there was a moratorium on new applicants, after a surge in start-ups (and failures). But exceptions were made to allow cases such as airlines launched in partnership with an existing carrier. Hence airlines like Tibet Airlines and Dalian Airlines, both tied to Air China, have launched during the moratorium. In 2012 HNA Group, of Hainan Airlines, stated its intent to launch Fuzhou Airlines and, more recently, Urumqi Airlines, amongst others.

The tide began to turn in early/mid 2013 with the announcement of Ruili Airlines, which was to be entirely privately owned (although all airlines in China have a degree of healthy government relations) and not connected to an existing airline. More recently the message from the CAAC hinted that a formal revision of the policy was on the way, even if the policy change merely matches what has become the status quo.

All of these planned up-starts have one theme in common: they are not operating out of the first-tier cities the way Juneyao and Spring established themselves in Shanghai last decade. Partially that is because slots are constrained and a new carrier would struggled to gain scale. But a factor is also China's push to move economic development away from the coastal area that has spearheaded growth.

The new start-ups are still in sizeable bases where there is strong growth potential. But merely being outside of a first-tier city does not alleviate slot concerns. New carriers are planned at Kunming and Hangzhou, where slots are relatively tight. A policy supporting new carriers will also be impacted by the major implication of aviation reform: progress without disturbing the status quo.

The new carriers will have to tread carefully when there is the prospect of competition with the state-owned ones. There can be some overlap but not significantly so. More challenging is that the definition of those terms will likely only be determined once they are reached. Effectively, once new airlines get past the welcome mat, how much support will there be for them? This topic will be addressed in a future CAPA report

Low-cost carriers will be supported and encouraged; the Spring and West Air examples

As a corollary to approving new entrants, LCCs will in future be supported and encouraged. This meshes well with another macro-reform some expect: supporting innovation to generate economic benefit from new and different channels. The potential application of LCCs in China is multi-pronged.

The basic theme is the same but there are nuances. There is the Spring Airlines scenario, the China West Air example and a future scenario.

The Spring scenario might be termed a model for greater efficiency. For Spring, following the LCC model has made it more efficient than state-owned competitors, and the CAAC has recently recognised this in a report. Spring's constraints are not shortage of customer demand but the number of slots it can obtain and the aircraft it can import; both are decided by the government. Because of its efficiency, Spring can fly more with a smaller number of aircraft than competitors, for example.

The West Air example could be seen to focus on having the right model for the right region. West Air, part of HNA and based in Chongqing, is transitioning to being a LCC. Its rationale is that Chongqing's economic development is lower than on the east coast, so salaries are lower than in Shanghai and the market is more price sensitive. Thus an LCC, with typically lower costs and thus fares, is suitable to regions still boosting their economy. HNA's transition of West Air from a full-service carrier to LCC could even suggest that not only is an LCC suitable but it is more suitable than a full-service carrier.

Another major deployment of a LCC is one that largely does not yet exist in China: to stimulate new traffic. There is no doubting Spring's accomplishments; even the CAAC vouches for them. But slots at is home base Shanghai are heavily constrained, so if Spring did not use the slots, some other airline would - potentially not with the same efficiency, but passengers would still be moved, albeit at higher prices. This scenario thus applies most where (i) there is plenty of available airport capacity and (ii) lower disposable income, requiring lower fares to stimulate travel.

An LCC in this third format would stimulate traffic once incumbents reach maturity. An example might be Allegiant or Spirit in the United States or easyJet or Ryanair in Europe. These have in common their use of open capacity. While easyJet and Ryanair do sometimes fight for access, the European market has greater slot availability (and alternative airports) than China. Allegiant's model involves flying from smaller, unconstrained cities that otherwise do not receive direct service to holiday destinations and Spirit typically moves into areas where consolidation has reduced competition and thereby freed up slots.

These Chinese examples apply where LCCs are independent. There is another format when contemplating if full-service airlines will have a low-cost subsidiary.

Now that China Eastern has taken the initiative in partnering with Jetstar to establish a JV LCC in Hong Kong, along with local interests, it is only a matter of time before Air China and China Southern also make a move, probably sooner than expected. After all, almost every full service in the Asian region has seen fit to establish at least one low cost subsidiary in one form or another.

An LCC subsidiary could be based in an entirely different city from its owner (and perhaps compete more directly with a full-service rival of the LCC's owner), it could operate alongside the full-service carrier to target various segments, it could take over existing lower yielding and unprofitable routes, or any number of combinations. Existing full-service carriers could for example move to a more hybrid operation, as has generally occurred in the US and intra-EU markets.

The likely strategy of the CAAC seems to be to promote the LCC model for regional operations while having existing major carriers adopt LCC tactics. China Eastern will have a first mover advantage through experience in its proposed Jetstar Hong Kong JV. Its intent in the project is commercial but also strategic, using it to understand the LCC model - and overall ways of efficiency - from the well-run Jetstar Group.

LCCs to date have largely operated outside of the aviation ecosystem planned by China, meaning they have to make their case for aircraft and slots. Reform is expected to bring them into the circle and make them a more definitive part of future growth. The LCCs will be moved out of limbo - but not given free rein. A myriad of detail regulation will ensure that fences are maintained in all sensitive areas. So although LCC policies may feature prominently in forthcoming aviation reforms, there will be no hands-off policy.

Ending the one airline-one route policy is sensitive but inevitable

There is no shortage of statistics or organisations proclaiming how big China's outbound travel market could be. Whatever the memo says, Chinese airlines are however largely ignoring it.

Air China has become a familiar sight in European airports while doubling some North American services; and China Southern's push into the Australia-Europe kangaroo route market is now well-known. But the heart and focus from Chinese airlines remains on the domestic market. Even with the international growth, international capacity is still about in the same proportion as domestic capacity, perhaps except at China Southern where there has been some disproportional growth over a few years.

Domestic and international split at Air China, China Eastern and China Southern: seats flown, 7-Oct-2013 to 13-Oct-2013

Carrier	Domestic/International Split
Air China
China Eastern
China Southern

Source: CAPA - Centre for Aviation and Innovata

Domestic flights not only generate a higher yield, they are typically profitable while international often is not. This prompts something of an unproductive circle. The majority of effort goes into supporting domestic operations.

The airlines, and China Southern especially, have genuinely improved international operations and the distinction - and achievement - is clear. (Air China for one says its North American call centre wait time has been reduced from a peak of 40 minutes to now 20 seconds.) But domestic still receives more attention, so the competitive factors on international routes are not seeing seismic changes.

Air China, China Eastern and China Southern yield (RMB per RPK): 2012

Source: CAPA - Centre for Aviation and airline reports (IFRS)

This is the argument for keeping in place the country's one airline, one route policy that generally means only one Chinese airline can operate a long-haul service. An exception is made for the Beijing-based flag carrier, Air China, to operate some routes from Shanghai. Indeed, Air China's clout ensures the policy remains, which is to Air China's benefit. Prohibiting Chinese competition allows time for the carriers to find their feet amongst foreign carriers, whom they (rightly) consider formidable, thanks not only to service product but to marketing and distribution.

Hainan Airlines and China Southern suffer the most from these restrictions. China Southern's primary base in Guangzhou has neither the political importance of Air China's Beijing base or the economic strength of China Eastern's Shanghai base. Guangzhou is the gateway for China and the world's manufacturing hub, and yields are low. For some time, China Southern's domestic yields lagged competitors (this has recently changed). So China Southern is pressed to find routes with suitable premium demand. Hainan is based in Beijing and so has to compete with Air China, which, unfortunately for Hainan, is also China's most international airline.

Hainan's long-haul network comprises points Air China has no interest serving, like Berlin and Seattle. Hainan has struggled to find a way to serve New York City. Air China flies to JFK so Hainan thought Newark might be a creative solution, but that was not warmly received in Beijing. Even serving New York as a tag flight from another North American destination requires lobbying.

China Southern has tried to mount long-haul flights from Beijing to key destinations that would be appropriate for its A380s. China Southern from Beijing serves Amsterdam (this feeds the hub of partner KLM) but wanted Air China destinations like Paris and New York for the larger A380s. Once China Southern was refused, it proposed to serve the routes in cooperation with Air China. Nothing has eventuated of this, except that Air China has been able to maintain status quo. China Southern's A380 domestic routes and forthcoming service to Sydney are seen as compromises. Politically, operating those routes is more prudent than keeping the aircraft grounded, which some speculate might be more economical.

It is unfortunate Hainan and China Southern are confined in this way. Hainan and its management are considered by outsiders to be China's most international and outward-thinking. Additionally, Hainan is lean, especially since it is not weighed down by clunky government-orchestrated mergers. There is no doubt that if Hainan, like Spring, was given free rein its success would be significantly larger than it already is and would force competitors to step-up their game. Already competitors feel slighted as Hainan is the only Chinese carrier rated with five stars by Skytrax; within Chinese airlines this is taken very seriously.

China Southern is admired by many outsiders for its entrepreneurship.

The carrier has worked extensively with Air France-KLM to develop a sixth-freedom strategy anchored around its Guangzhou hub. China Southern is contrasted to China Eastern, which is blessed with a hub in the country's economic centre but, with a slow moving and top heavy management, has done little with it. (In China Eastern's defence, it pinned long-haul growth on the arrival of the 787 in 2008; not only were deliveries repeatedly delayed, China Eastern concluded production differences mean the 787 could no longer reach targeted destinations with an optimal payload. It has thus ordered no less than 777-300ERs, clearly signalling its intentions.

There have been discussions within the CAAC to modify the one airline-one route policy. Despite sound practical grounds for change, the power brokers' views still prevail and any change will most probably be incremental and carefully monitored.

China's aviation technology monopolies could be broken up

Some of the reforms will slightly (initially, at least) eat into the Big 3 carriers, all state-owned and collectively accounting for half of the capacity in the domestic market. (This figure rises when including subsidiaries and affiliates.)

But there are some reforms that could be very much to their benefit and which they also may be pushing for.

China domestic seats by carrier: 7-Oct-2013 to 13-Oct-2013

Source: CAPA - Centre for Aviation and Innovata

One such area is ending the monopoly of government-owned TravelSky in certain areas. While airlines can already mix and match service providers for some products, TravelSky's pricing incentivises airlines to use all of TravelSky's services. This makes it expensive to use another provider. It is clear to airlines that TravelSky has significant drawbacks, such as weaker control in its GDS product. Airlines cannot for example hide planned routes while travel agents can "un-marry" sectors to take advantage of better fares at another city.

Website development has been a recent push at the carriers, mainly for domestic purposes but also for their growing international networks. The carriers are finding TravelSky's offerings limited to international providers.

Ending TravelSky's monopoly could provide better services and lower costs to the airlines as TravelSky would more evenly pro-rata its offerings. While technology may not be a glamorous area, it directly impacts how - or if - bookings are made. It is also an area for efficiency and significant cost savings, and this would be welcome given the carriers were generally operationally unprofitable in the first half.

For TravelSky itself the experience too may not be so unpleasant; there is massive upside in the market and there is nothing like a little competition to stir innovation. Whatever happens it will remain in pole position for some time to come.

Government austerity measures have caused premium traffic reductions

China's new government entered office at the start of 2013 and quickly put austerity measures in place to reduce what is seen by the public as lavish examples of wealth from officials that is either inconsistent with the rest of the country's lower economic position or is the result of corruption.

There is debate if structural change is being made or if only superficial changes are being implemented to appear to tackle the problem. Regardless, the impact for airlines is that their premium revenues have decreased by upwards of 20% in some cases, according to some estimates, as the government cracks down on unnecessary premium travel. Overall, carriers saw a premium dip of around 10% earlier in the year while passengers using VIP lounges decreased by 20%.

Some airlines like Air China resist acknowledging a downturn, but China Eastern and China Southern have not minced words. China Southern went so far to say it was considering removing first class, although this may not be exclusively tied to government premium traffic.

The concern at the start of the year was serious, and not expected to be cleared up until the reforms towards the end of the year. The expectation is that pressure will continue, at least in the short term.

See related report: China Southern Airlines considers removing first class, with China's new government austerity

This compounds the weak premium revenue that is challenging Chinese carriers, with their cost conscious travel market.

Premium revenue comprises about 13% of Air China's passenger revenue. This is substantially less than the 20% seen at Korean Air, 25% at Thai and higher at others. Even adjusting for Air China's predominantly domestic focus, premium revenue is weak. Domestic first class is often only twice the price of discounted economy, or sometimes less.

Air China premium class revenue (RMB100 million) and share of total: 2009-2012

Source: CAPA - Centre for Aviation and airline reports

See related report: Chinese airline outlook: slot shortages and yield pressures prompt the need for innovative solutions

There is overlap in this area with the likelihood of LCC subsidiaries. Dual-brand strategies cannot be accomplished without one brand being premium and attracting premium yields.

Qantas-Jetstar may be the gold standard, but in that relationship is a very premium experience at Qantas that is accompanied with investment in lounges and product that may not generate a return in China. The impact of these decisions is significant: it will shape the direction of China's domestic market. China will effectively try to plan what took the US and Europe nearly of decade of gradual changes and experimentation.

Growth cannot occur under current airspace constraints; and major companies remain inefficient

It is difficult to discuss China's aviation growth without mentioning the severely constrained airspace that limits flights. Even if airports did not add more runways, merely improving air traffic control would substantially increase the number of flights they could handle (this is true globally, but especially so in China).

But the aviation industry is limited in its ability to lobby for change. Airspace is controlled by the military, which by the CAAC's estimate makes only about 20% available for public use. The military is a mighty institution with extensive influence and power that few government bodies can touch. Reform in this area is deeply needed, as increased media attention has shown. There have been piecemeal efforts such as the recent opening of additional routes around Beijing, but substantial changes await, and this it seems can only come from the top.

Also largely beyond the control of aviation is the need for deep reform at state-owned enterprises like the Big 3 airlines. Productivity and efficiency are low, even by global standards. Significant changes awaits the entire SOE sector but given the political importance and number of jobs the SOEs furnish, this may wait for another day.

Outlook: balancing an academic wish list with what is politically achievable

US news magazine Time in Aug-2013 attacked what it termed China's "shoddy state-run airlines" and bemoaned a "mismanagement epidemic" at the airlines. It is true there is inefficiency, that Chinese carriers are not reaching their full potential and that improvements could be made in management. But this is the product of the system; it is not an intentional outcome.

There are some executives and regulators, frequently at the top, who have a clear vision of an efficient Chinese aviation system that, if implemented, would make others jealous. Their enthusiasm and dedication is sincere and admirable. But they are limited by those with inertial influence who can shape policy to what benefits their power network rather than the public. This is emulated in the wider government in China but also abroad (to varying degrees).

So the implementation of policy shifts from what is on an academic wish list to what is politically achievable, either outright or through negotiations. While reformers - in aviation and more broadly - need to decide how much easing of control they will permit, they also have to confront how willing they are to take on vested interests and how much ground they can gain.

The full outcome of those factors will not be immediately apparent. While the Shanghai free trade zone opened in Sep-2013 with great fanfare, few were clear what the policies were - or even how many existed. The details will take time to flow and will be adjusted along the way. The same will undoubtedly also apply to aviation reforms.

Nonetheless, the signs so far are encouraging. Efficiency is a focus and support is being given to permit new carriers to launch.

But entry is one thing, survival another. The nature of the regulatory environment into which they will be launched is likely to remain cloudy and malleable - as opposed to the ideal of a clear and transparent operating regime.

China is moving ahead, and probably fairly fast now, as LCCs invade the region; but the powerful interests of the Big 3 airlines will continue to dominate and complicate any direct movement forwards.