China`s first private airline in 50 years has started service. But while more are on the way, foreign low-cost carriers could be the biggest threat to existing domestic airlines. By Dominic Jones.

Okay Airways is a curiously modest name for a carrier which has dared to be China`s first low-cost airline and its first wholly private operator. Symbolically, the introduction of a low-cost carrier into the Chinese market is an important development. However, a number of major hurdles will limit the growth of the low-cost carrier sector, including continuing restrictions on the way airfares are set.

By itself, the emergence of Okay Airways, which bases its operations at Binhai International Airport, near Tianjin, is not a development that will worry even China`s lesser carriers.

The airline flies one 737-900, sub-leased from Korean Air, and says it intends to lease three in the short term and then expand to six over the next few years. Even by start-up standards this is an unassuming business plan.

No doubt fearful of its chances if restricted to the passenger market alone, Okay Airways plans also to run air cargo and express services. Several private shareholders, including a logistics company, which will integrate the airfreight business with its own ground distribution operations, own the airline. Okay starts with a registered capital of Rmb300 million ($36 million).

Government policy

Far more important than Okay Airways` own plans is the Chinese government`s overarching ambitions for the low-cost market. Okay Airways owes its existence to a decision by the Civil Aviation Administration of China (CAAC) to allow any company with three aircraft to operate an airline.

``Foreign investors are allowed to invest in these private airlines up to a maximum of 25% of registered capital,`` says a lawyer who has previously advised on foreign investments in the Chinese air transport market.

Ma Zheng, deputy director of the CAAC`s department of policy and regulations, adds that a draft version of a regulation allowing airlines to be wholly owned by the private sector has been completed. The regulation will provide a legal basis for the injection of private capital into the sector.

The draft regulation is undoubtedly a positive development, but observers note that the government is still moving slowly and cautiously on the issue of low-cost airlines. ``A year ago the market was abuzz with speculation about a low-cost boom and there was talk of at least 10 potential new operators, but it has taken until now to get even one budget airline approved,`` says an analyst in Hong Kong.

Lawyers say the list of potential new entrants that are waiting for government approval to begin commercial operations include United Eagle Airlines, which plans to operate from Chengdu, and two other start-ups, Air Spring and Huaxia Airlines. The government`s stance on the low-cost sector will be uncovered by its handling of these pending applications. But at present it remains to be seen how many of these airlines will be granted approvals and how quickly.

Indications of a cautious approach to the budget airline market are also to be seen, says Alan Lam, airline industry analyst at Guotai Junan Securities, in the sort of routes earmarked for Okay Airways and other proposed low-costs. ``The CAAC has not yet given approvals for low-costs to fly major domestic routes,`` says Lam.

The government`s decision in principle to allow private sector start-ups into the airline market can be contrasted with the strategy of the past five years of promoting industry consolidation.

Peter Harbison, managing director at the Center for Asia Pacific Aviation, says that the previous wave of new carriers entered the Chinese market 10 years ago. Those new entrants were backed not by private enterprise but provincial governments throughout China. The government has not forgotten that the introduction of these airlines, plus their ambitious expansion plans and an economic slowdown, led to a fierce fare war in 1998, which ended in the closure of some carriers and the merger of others into the three major groupings seen today.

But the authorities recognize that the airline market is in much better shape. The CAAC says that profits in the Chinese aviation industry grew to $1 billion in 2004. Domestic passenger trips rose 38% to 120 million (albeit a large part of that increase was the bounce back from the Sars crisis). In 2005, the civil aviation body expects the industry to grow by 15%. The Chinese government is also eager to promote the overall domestic tourism market, and believes a low-cost carrier network will stimulate tourist numbers.

Despite the recovery in the Chinese airline industry, analysts say incumbent airlines have urged the government not to allow a rapid rise in the number of new domestic airlines. ``The traditional carriers will be emphasizing the threats that still exist to the airline industry, particularly in the form of higher fuel costs, and will therefore be asking the government not to bring in too many new competitors,`` says Lam.

Perhaps lending greater credibility to the industry`s lobbying effort, analysts expect earnings growth to slow this year for existing Chinese airlines, because of a 12% rise in jet fuel rates, which went into effect last month. The country`s top economic planning body, the National Development and Reform Commission (NDRC), has raised jet fuel prices for the second time in seven months to Rmb4,140 per ton because of recent rises in international crude prices.

In turn, the country`s jet fuel monopoly, China Aviation Oil Group, has followed suit and raised retail fuel rates. Given the already competitive market environment, Chinese carriers are unlikely to pass on the additional fuel cost to passengers and operating margins are expected to suffer.

Low-cost obstacles

Chinese airlines, already wary of the potential impact of low-cost airlines given their successes in Europe, are likely to try to push new competitors out of the market before the new entrants have any chance of establishing themselves.

Observers believe start-up airlines will be at a substantial disadvantage in China if no regulations are put in place to prevent seat dumping, cross-route subsidization and other anti-competitive methods. So far the authorities have not addressed this issue.

Already, at least one carrier, Hainan Airlines, is adopting an anti-competitive strategy towards Okay Airways. Hainan has restarted a service on the only route Okay is flying. Okay would otherwise have a monopoly on this route.

A number of other major obstacles exist for low-costs, the most significant of which is the lack of a fully liberalized air ticket pricing mechanism. Admittedly, some progress has been made in relaxing the ticket pricing system. Timothy Ross, analyst at UBS, says airlines no longer have to follow a revenue-pooling approach. Under that approach operators were allocated a share of total industry revenues made on each route, according to the number of seats they provided on each route.

Prices on short, local routes now fluctuate freely after a new regulation came into effect on April 20, 2004. The Domestic Air Transportation Price Reform Plan also allows prices on other routes to float 25% above or 45% below the per passenger-kilometre base price set by the government.

Harbison says the relaxation of the pricing mechanism led, in the short run, to higher rather than lower prices. Carriers raised fares by up to 25% because of higher fuel costs and strong holiday travel demand.

An insufficient number of suitable secondary airports is often suggested as another reason why low-costs in Asia are disadvantaged compared with their peers operating in western Europe. However, in China analysts say that the existing airport infrastructure can support a vibrant no-frills airline sector.

Harbison says China`s east coast has the greatest potential, initially, for low-cost market development. There are numerous underutilized airports, but despite the excess capacity in certain regions, new airports have been constructed at a rapid pace, even in the Yangtze Delta.

According to a civil aviation official, more feeder airports will be built in eastern China. The CAAC`s east regional administration is planning to build eight new feeder airports and expand some trunk-line airports by 2020.

Additionally, as the major hub airports, such as Beijing Capital International Airport and Shanghai Pudong International Airport, are new builds, capacity constraint will not be a concern for at least 15 years (assuming growth projections for passenger and cargo traffic are correct).

Airport costs are an additional concern for low-cost airlines. At the moment, airports in China tend to follow pricing guidelines set by the CAAC, but market commentators believe low-costs would benefit from a degree of flexibility in pricing.

``Airports have offered discounts on airport charges in the past. These discounts have tended to be for new entrants and foreign airlines,`` says one source. The source also believes that the government is planning to create a more formal set of regulations governing fees and charges set by domestic airports. However, it is not clear if the new regulations will be more or less generous to the no-frills segment.

As Chinese low-costs are likely to want to adopt similar internet-based ticket sales strategies as their overseas counterparts, in order to keep operating costs as low as possible, a positive trend for potential low-cost operators is the rapid increase in internet usage in China. The internet usage rate is still low compared with developed economies, but it is expected that the proportion of people using the net will continue to rise for at least a decade. According to some reports, about five million new Chinese users go on line each month.

Selling tickets online, however, works best if most passengers have credit cards. Between 20% and 25% of consumers in China`s three major cities have credit cards, according to AC Nielsen, the marketing information company. In China as a whole the figure is much lower: 3%, about equivalent to a market of 40 million. ``For the moment, budget carriers in China will have to rely mostly on travel agents for their sales, and this will drive up costs and reduce their capacity to compete,`` says one commentator.

However, low-cost carriers such as AirAsia and menaJet have managed despite the lack of credit cards in their home markets.

Foreign low-cost carriers

While new domestic carriers are being launched, China`s traditional carriers are likely to face a greater competitive threat from overseas low-costs.

At the beginning of 2004, the CAAC director-general Yang Yuanyuan announced a more competition-driven aviation policy for international traffic rights. The move was accompanied by the liberalization of traffic between China and Thailand. China has also recently signed more liberal air services agreements with Singapore, the US and South Korea. This liberalizing trend opens up major opportunities for the budget airline sector.

AirAsia, the South-East Asian low-cost, is one of the airlines to have benefited from this new policy, having been granted approvals to fly to and from China. The airline plans to launch its first China service in Xiamen on April 25 (flying between the east coast city and Bangkok), making it the first foreign no-frills carrier to operate in China. The flight will be run by AirAsia`s joint venture in Thailand. The CAAC has also granted AirAsia the right to fly to two other Chinese destinations, Chengdu and Kunming.

Lam suggests the Asian low-costs have a competitive advantage over Chinese airlines. ``Local Chinese airlines need to pay higher fuel costs, aircraft import taxes and route charges, which low-costs outside China do not pay,`` says Lam. Fuel costs are typically 20% more in China than overseas, but the operating cost disadvantage may be reduced over the next 12 months because the Chinese authorities are also considering plans to liberalize the jet fuel business, and lower landing and administrative fees for airlines.

Expanding the market

Notwithstanding their operational advantages, analysts do not expect severe competition from low-cost carriers in the rest of Asia. For the moment at least, Asian low-costs do not have sufficient aircraft capacity to make a major impact on a market the size of China`s.

Furthermore, industry experts do not expect a flood of foreign rivals because the CAAC is only likely to open the market to foreign low-cost airlines slowly, in order to protect homegrown carriers.

Experience elsewhere has shown that low-costs help to expand an aviation market and should not be seen simply a competitive threat for more traditional operators.

Air travel in China is expected to grow 19% to 104 million passengers this year and, over the next 10 years, growth is forecast by the CAAC to remain in double digits each year. Given this, and the fact that only about 1% of the Chinese population travelled by aircraft last year, either within China or abroad, low-costs will have plenty of room to thrive alongside China`s existing airlines. The key question is, will the low-cost airlines be able to surmount the disadvantages facing them in the Chinese market?

The low-costs will, at least, have the support of the local travel agency business. ``Driven by the belief that the budget market will lead to even faster growth in China`s tourism market, tourism operators have been the ones trying to drive a new budget industry in China,`` says Lam.

Tourist group-backed ventures include Spring Airlines (formed by the Shanghai Spring International Travel Service and the Shanghai Spring Charter Plane Travel Service). Spring Airlines aims to begin its service with Shanghai as its base.

Another travel agent, state-owned Guangdong China Travel Service Holdings, will partner with China Xpress, Singapore`s A-Sonic Aerospace and Singaporean air cargo operator AirOcean Group for another (as yet unnamed) airline.

These airlines, and others, could change the domestic market. That would be okay for everyone who wants to do business in China.