ANALYSIS: China's regional market begins to take off

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China’s regional aviation market has long been ignored as a result of low volumes and a shortage of regional aircraft. But there are signs that airlines are starting to pay more attention as they look to diversify away from the crowded eastern China market, in search of new growth opportunities in the country’s rapidly developing central and western regions.

Last year’s China Regional Aviation Forum, jointly hosted by Embraer and the Civil Aviation Management Institute of China (CAMIC), put the spotlight firmly on the Chinese regional aviation sector. The Civil Aviation Administration of China (CAAC) broadly defines regional aviation as low-volume air passenger services at airports serving fewer than two million passengers per annum, on routes serving at least one such airport using aircraft with fewer than 100 seats. Regional aircraft, as per CAAC, are aircraft with fewer than 100 seats.

Based on these criteria, China now has close to 150 regional airports and 200 regional aircraft. Most regional airports and regional flight routes are concentrated in the vast, less-developed central and western regions of the country.

The low-volume, low-fare markets in these regions partially explain why China’s regional aviation sector is still in its infancy while air traffic growth between hubs and major cities in the country’s economically strong eastern region has skyrocketed over the past decade. In 2009, the central and western regions contributed just 37% of China’s GDP, with average personal disposable income significantly lower than in the east. Although more than half of the Chinese population resides in the central and western regions, the citizenry is scattered throughout a vast area, making the markets less attractive to the profit-driven domestic airlines.

A shortage of regional aircraft has also prevented China’s regional aviation market from taking off. Of the 1,941 commercial aircraft in China in 2012, less than 10% were regional aircraft. By contrast, regional aircraft comprise nearly 40% of the US commercial passenger fleet.

China’s high import taxes for regional aircraft are largely to blame. To protect its aircraft manufacturing industry, the Chinese government collects much higher import taxes on small aircraft (weighing 25t or less) than on larger aircraft, which greatly increases their operating costs. As a result, using mainline aircraft to operate regional routes has become commonplace in China. In fact, more than half of the total passengers in the regional market in 2012 were transported by mainline aircraft. The mismatch between aircraft types and markets served means reduced frequencies – which in turn negatively affects airline profitability. Other factors, such as difficulties in obtaining take-off and landing slots for small aircraft at hub airports and airlines’ limited pricing power on regional flight routes, also lower market confidence in the regional sector.

Domestic airlines have, therefore, rushed into the lucrative markets in eastern China, leaving regional airports in an awkward position. On the one hand, the number of regional airports has steadily increased over the past decade but many of the airports are severely underused. While 75% of China’s airports are regional, these airports collectively transported less than 10% of the total number of passengers in 2012. As a result, the idle regional airports in many provinces have become financial burdens for local governments. On the other hand, however, operating mainline aircraft on regional routes has forced these airports to upgrade their facilities in order to accommodate larger aircraft. The number of larger regional airports has increased dramatically over the past five years, but many are struggling financially.

Unlike in the USA, where more than 50 regional airlines play an essential role in feeding traffic to major airlines’ hubs, China has very few regional airlines. Joy Air and China Express are among the country’s most recognised regional carriers, but with only 20 regional aircraft in total, their market share is minor. At present China’s major airlines – namely Air China, China Eastern Airlines, China Southern Airlines and Hainan Airlines – are still playing a major role in regional aviation. Over the years, they have viewed the high-cost, low-profit regional market merely as a small supplement to their trunk markets. Many have called for a government programme like the USA’s Essential Air Service (EAS) programme – which subsidises small communities across the country that would not otherwise have received scheduled air service – to put China’s regional aviation on the right track. The Chinese government has increased subsidies to the regional aviation market in recent years, but a comprehensive programme similar to EAS is still lacking.

Even without a government programme, the airlines’ view on regional aviation has started to change. The traditional market in the eastern part of China has become increasingly competitive, particularly with the near-completion of a high-speed rail network, leaving major airlines little room to grow. The central and western regions, with little threat from high-speed rail, may offer new opportunities for profit growth.

And the major airlines have found other motivations to “go west” – they are the biggest beneficiaries of government subsidies for regional aviation. Air China, China Southern and China Eastern, for example, were collectively allocated 60% of the total $62 million subsidies in 2013. Joy Air and China Express, by contrast, were granted just 3%.

More importantly, the rise of some resource-rich central and western provinces – particularly Inner Mongolia, Xinjiang and Yunnan – has stimulated demand for regional aviation to levels never seen before. Inner Mongolia, for instance, has achieved rapid GDP growth over the last five years, and has become increasingly reliant on air transportation to maintain its fast-track economic development. Interestingly, Air China, China Southern and China Eastern each hold a dominant market position in these three provinces. Recognising the value of establishing spokes in the regional markets to facilitate the growth of their hubs, they have now used these provinces as entry points to gain more control over the regional markets.

Air China’s regional aviation experiment started in 2007, when it increased its stake in Shandong Airlines to become its largest shareholder. The aim was to take advantage of Shandong Airlines’ regional route network and open up the regional market in southwest China. With mixed results, Shandong Airlines gradually moved away from the regional market to become a mainline carrier. However, the airline still flies seven Bombardier CRJ regional jets.

Inner Mongolia presents a new opportunity for Air China. Passenger numbers at Hohhot airport exceeded four million in 2012, but many of the 12 regional airports in the province remained underused. With the economic prosperity of the province, these regional airports have experienced growing traffic. Recognising the value of the regional market to its hub development, Air China worked with the Inner Mongolia government to establish Inner Mongolia Airlines in 2012, aiming to connect the in-province regional airports with more flight routes and enhance the regional feed from these airports to Hohhot. Meanwhile, the new airline will increase services from Hohhot to Air China’s hubs and focus cities across the country, integrating the regional market into Air China’s domestic route network.

Over the years, China Eastern has explored the regional markets around its Kunming and Xi’an regional hubs in Yunnan and Shanxi provinces, with the former achieving much greater success. Yunnan province has the advantage of popularity among tourists, making it a key market and an important revenue contributor for China Eastern. Although the airline acquired Yunnan Airlines following industry reform in 2002 – and has since enjoyed a dominant market position in the province – it was not until 2010 that it established China Eastern Yunnan Airlines with the local government to accelerate the regional aviation development.

The new airline set a goal of developing four route networks around Kunming. The first will connect the 11 in-province regional airports to Kunming airport with enhanced feeder services, while the other three route networks will connect Kunming to more domestic, Southeast Asian, and other international destinations.

Clearly, the cultivation of the regional market within the province plays an essential role in the development of the larger networks. It also allows China Eastern to better compete with the 37 airlines operating scheduled flights to and from Yunnan province. China Eastern Yunnan Airlines plans to expand its fleet by 30% to reach 75 aircraft over the next two years, in order to strengthen its market position in Yunnan – one of the most competitive air travel markets in China.

Similar to China Eastern, China Southern acquired Xinjiang Airlines in 2002 to become the largest airline in Xinjiang. Its regional aviation ambitions, however, were triggered not only by the province’s increasing need for regional aviation but also by government policy towards regional aviation in Xinjiang. As China’s largest province, Xinjiang accounts for one-sixth of the nation’s land area, and shares borders with eight countries. Its geographical restrictions, together with its rich resources and rising economy, highlight the need for air transportation.

A number of policies have been introduced by the CAAC in recent years to encourage the development of regional aviation in Xinjiang, specifying the need to establish two route networks within the southern and northern parts of Xinjiang, respectively, to enhance air connectivity and accessibility in small and remote communities. China Southern quickly responded by establishing a regional fleet consisting of 10 97-seat Embraer 190s. Following an 8% increase in regional traffic in the first half of 2013, China Southern deployed Boeing 737-800s on the busy regional flight routes connecting the fast-growing regional airports to Urumqi airport – the capital airport of Xinjiang and China Southern’s third hub in China, after Guangzhou and Beijing. Meanwhile, two 777s have been added to the mainline fleet to boost capacity between Urumqi and China Southern’s major hubs across the country. A plan to establish a regional airline with the Xinjiang government is also on China Southern’s agenda.

While China Southern is well known for its fast-growing regional fleet serving the Xinjiang market, Hainan Airlines was quicker off the mark to establish its own. It launched Tianjin-based Grand China Express in 2007, which at the time was China’s largest regional airline, with a fleet of 29 Dornier aircraft. In 2009, Grand China Express was renamed Tianjin Airlines to become the local airline of Tianjin. Despite moving into mainline markets, Tianjin Airlines is still by far the largest regional flight provider in China, operating a fleet of 50 E190s, 23 Embraer ERJ-145s and six Airbus A320s.

In 2012, the airline flew to 34 regional airports throughout Tianjin and its seven operating bases, carrying nearly half of China’s regional passengers. Through Tianjin Airlines and its many subsidiaries, Hainan Airlines has become the strongest competitor of the “big three” airlines in China’s major regional markets. It is the second-largest market shareholder after China Southern, Air China and China Eastern in their dominant Xinjiang, Inner Mongolia and Xi’an regional markets. In Yunnan it holds a 17% market share, right after China Eastern, through subsidiaries including Lucky Air, Capital Air and West Air.

Although Hainan Airlines has faced increasing challenges in the mainline markets due to the rapid expansion of the big-three airlines, its early-mover advantage has allowed it to achieve significant growth in many regional markets, making it the most active player in these markets.

Undoubtedly, China’s major airlines will continue to play a dominant role in the nation’s regional aviation for a long time, but regional and private airlines in China still have room to grow. China Express, for example, teamed up with Dalian Airport Group in 2012, with the aim of expanding its fleet over three years to feed the airport with more transit traffic through its regional route network. The localisation of regional aircraft will also bring opportunities to these airlines. Okay Air – China’s first private airline – recently disclosed its intention to buy 20 Xian Aircraft MA60 turboprops to establish its own regional airline.

The development of regional aviation in China will become more dynamic in coming years. While major airlines will dig deeper in regional markets, enhance feeder services and consolidate more traffic into their hubs to gradually move towards a hub-and-spoke system, private and regional airlines will find their niche markets and slowly catch up.

It will be a long time before regional aviation becomes an important building block of the passenger air transport system in China, but there are encouraging signs that regional aviation is attracting serious attention and is ready to take off.