Chinese air transport specialist Jane Pan looks at how overseas funding in Chinese airlines has not matched that in the general economy and has been almost non-existent since 2002. Yet the needs for strategic partners to drive their international expansion may signal the return of capital from abroad.
China has become one of the world's largest recipients of foreign investment. According to the Ministry of Commerce of China, the nation used $116 billion in foreign investment in 2011, up nearly 10% year on year. Yet only a very small part of this investment has reached the air transport industry, which has only accumulated $30 billion in foreign investment over the last 30 years despite its rapid development.
The industry had its first contact with foreign investment in 1980, when China acquired its first Boeing 747SP through leveraged aircraft leasing from a US investor. Yet it was the issuing of the regulations on foreign investment in Civil Aviation in 1994 that capped foreign ownership at 35%, forming the legal framework for foreign investment in the industry. In 1995, Hainan Airlines announced a $25 million investment from American Aviation and became the country's first carrier to utilise foreign investment.
The regulations not only opened the door for foreign investment to enter the industry, but also paved the way for the domestic carriers to seek foreign investment in the international markets. In 1997, China Eastern Airlines became the first Chinese carrier to simultaneously be listed on the New York and Hong Kong stock markets, generating $280 million. Later in the year, China Southern Airlines was listed in New York and Hong Kong, generating a record $873 million. The capital accessed from international financial markets played a significant role in facilitating the growth of the newly established Chinese carriers.
Regulations were revised after the government regrouped the nine domestic airlines into Air China, China Eastern and China Southern in 2002. Raising the foreign ownership limit to 49% and giving foreign investors more management control, the new regulations revealed the government's intention to encourage the three merged carriers to tap into a broader range of capital sources in order for them to expand quickly. However, the regulatory support, plus the soaring economy, saw mixed results.
On one side of the picture, the domestic cargo market embraced the new regulations. Struggling between strong cargo demand and limited transportation, domestic cargo companies quickly tapped foreign investment to establish cargo carriers. Jade Cargo International became China's first air cargo joint venture, bringing in investment from Shenzhen Airlines, Lufthansa Cargo and German Investment and Development.
On the reverse side of the picture, most passenger airlines showed little interest in furthering their financial ties with foreign investors. Over the past decade, China's three main carriers have brought in virtually zero foreign investment. Yet this should not be interpreted as a low growth strategy. In fact, by focusing on hub development, fleet building and route expansion, Air China, China Southern and China Eastern have achieved tremendous growth over the last decade. Collectively, China's main triumvirate carried over 200 million passengers in 2011. Since 2002 they have seen a four-fold increase in aircraft numbers and seven-fold in passengers carried.
Not surprisingly, there were attempts by airline groups to take advantage of favourable foreign investment policy. In 2007, China Eastern announced it would sell a 26% stake to Singapore Airlines and Temasek Holdings, a Singapore state-owned investment company. By purchasing the newly issued shares of China Eastern at a subscription price of HK$3.8 ($0.49) per share, SIA and Temasek would have provided China Eastern with HK$7.16 billion, which would have been used to improve China Eastern's capital structure and financial position.
With the heads of agreement signed at the end of 2007, the deal was heading to completion when it was voted against by China Eastern's minority shareholders. China National Aviation Holding, Air China's parent company, proposed a counter offer 32% higher than that of SIA, eventually blocking the deal.
The absence of foreign investment in the airline passenger market after 2002 should be examined in the context of the changing economic environment. Unlike the 1990s, when China just started to transform from a government-controlled economy to a market economy, the years after 2002 have seen China's economic rise, which has brought tremendous opportunities for the air transportation sector.
While diversified financial sources were essential for the new carriers to take off in the 1990s, the quickly-developed domestic market in the last decade has allowed China's major carriers to make decent profits and accumulate working capital. Air China, for example, has been profitable every year since 2003 except for 2008, during the recession. The carrier achieved an accumulated profit of $3.3 billion and tripled its total assets from 2003 to 2010.
In 2011 Air China and China Southern were ranked by IATA as being among the five largest airlines in the world by market capitalisation, at $20 billion and $11 billion respectively.
This left China Eastern the only one struggling with financial difficulties after the industry merger in 2002, which explains its motivation to seek foreign investment. It solved the management problems after restructuring in 2010, steering the business in the right direction and posting impressive profits for the year. Indeed financial self-sufficiency has allowed the major domestic carriers to stand alone. And government subsidies in extreme situations, such as the capital injections for the big three carriers during the global economic crisis in 2008, further eased their financial burden, reducing the need for foreign investment.
Yet, it is not all about money. Many times, airlines have brought in foreign investment in order to gain access to new markets. JetBlue, for example, by bringing in Lufthansa as a strategic investor, has taken advantage of the Star Alliance carrier's extensive route network to enter the European market.
But such motivation has remained low for Chinese carriers over the years, primarily because of their over-reliance on the expanding domestic market. The market has grown so fast that passengers carried accounted for nearly a quarter of China's population in 2011, a three-fold increase from 2002, and the number is set to double by 2020.
Keeping themselves busy domestically, Air China, China Eastern and China Southern have opened international markets more slowly. International passengers accounted for 9% of total passengers in 2002, but only 7% of total passengers in 2011 - although actual numbers have increased substantially.
The motivation has been further reduced by strong competition from foreign carriers. Limited international network coverage and marketing strategies, means domestic carriers find it hard to make money on many of the international routes they fly. This has further diminished their interest in forming strategic partnerships with foreign investors.
The possible impact a strategic investor might have on domestic market competition has always been a sensitive issue for domestic carriers, and this may play a role in their decision about utilising foreign investment. The heads of agreement between China Eastern and SIA in 2007, if carried through, would have allowed SIA and Temasek to nominate three directors to the board of China Eastern, to help the latter improve management and corporate governance. Such an arrangement would have potentially changed the competition structure in the domestic market through the companies' influence on China Eastern's decision making.
This may have brought particular concern for Air China and China Southern, which both went through a long integration process after the 2002 merger. Compensating for the weakness of their new networks, they found the first few years after the merger particularly important as market competition was far from established then, giving them opportunities to optimise their domestic networks.
Foreign strategic investors, if deeply involved in airline management, would possibly change the competition dynamic among the major players in the domestic market. Maintaining the status quo, on the other hand, avoids such uncertainty, paving the way for the domestic players to establish their competition structure based on their own decisions.
The domestic competition structure has undergone a dramatic change since 2002. Air China acquired Shenzhen Airlines to develop a competitive advantage in southern China. And China Eastern, by acquiring Shanghai Airlines, has strengthened its leading position in central-eastern China.
While it is hard to predict the scenario if China Eastern had teamed up with SIA, there is no denying that the self-directed development of China's main three carriers has turned them into strong competitors domestically, building a solid foundation for them to grow internationally.
Caution in bringing in foreign investment has also resulted from watching the struggles in the cargo market. The domestic cargo carriers have increased their annual volumes, but lost market share to foreign competitors flying to and from China. While in the 1990s, Chinese cargo carriers held 65% of the market share in international cargo, this shrank by almost half by the end of 2009.
A lack of competitiveness because of their small size and limited network coverage contributed to the loss of business to foreign competitors. Bringing in foreign investment did not seem to solve the problem, as a number of cargo joint ventures, including Jade Cargo International, were forced out of the market following the global economic recession in 2008.
To enhance competitiveness, China Cargo Airlines, a subsidiary of China Eastern, merged with Shanghai Airlines Cargo and Great Wall Airlines to form the country's largest cargo carrier in 2011.
Shortly after, domestic cargo giant Air China Cargo was jointly established by Air China and Cathay Pacific. Based in Shanghai, it is led by a board consisting of seven directors, three of which are appointed by Cathay, in order to combine Air China's domestic advantage with Cathay's extensive international experience and global cargo network.
Such experience and network access have become increasingly valuable for the major domestic passenger carriers, as they shift their focus to the international market. Now, they have more compelling reasons to do so.
Firstly, the rise of high-speed rail in China has taken away market share from passenger airlines. And competition will only get stronger, as the planned high speed rail network develops. Upon completion in 2020, it will nearly overlap the domestic air route networks. Time has become important for the major domestic carriers to quickly open up the international market in order to compensate for the loss in market share and revenue in the domestic market.
Secondly, China's triumvirate of carriers, supported by their growing hubs, are now able to go beyond merely opening point-to-point cross border routes to getting involved more in meaningful international competition.
SkyTeam carrier China Southern, for example, has successfully leveraged the geographic advantage of its Guangzhou hub to connect China and Australia, becoming the biggest Chinese carrier in this market. Now, it has opened a Guangzhou-London service and is increasing frequencies between Guangzhou and major Australian cities, aiming to establish Guangzhou as a new connecting point between Europe and Australia.
While the growth of the Guangzhou hub, now ranked second domestically and 19th worldwide by traffic, has paved the way for China Southern to enter this high-profile market, the carrier has faced strong competition from rival international carriers on the kangaroo route. And the planned partnership between Qantas and Emirates in this market will further intensify the competition.
Without a well-developed international marketing strategy and management experience, China Southern would find it difficult to succeed against such heightened competition. While developing a competitive advantage may take a long time, bringing in investors focused on building a strategic partnership would be a likely alternative to prepare the Chinese majors for international competition.
Foreign investment in China's air transport industry has seen ups and downs over the past three decades. While playing an important role in facilitating the growth of Chinese carriers in the 1990s, it has remained uncultivated land since 2002. But the pressing needs of Chinese major carriers to speed up international expansion may reopen the door.
Yet, unlike the 1990s, when financial needs topped the industry's priority list, domestic carriers will now focus on building strategic partnerships with foreign investors to improve their marketing and management experience needed for international expansion.
The organic growth of major Chinese carriers over the past decade has placed them in a much better position to handle the issue of strategic investment. The government has reiterated its support, but is encouraging the carriers to bring in foreign investment that benefits both the development of the carriers and that of the domestic air transport industry.
China Eastern has taken fresh action. In March it outlined plans to form a Hong Kong-based low-cost carrier with Qantas. Successfully turning around the loss-making company after acquiring Shanghai Airlines, China Eastern is now tapping into the growing Asian low-cost market with the help of Qantas.At the same time, it has expressed an open attitude toward strategic investors and partnership.
With the domestic competition structure and the international focus increasingly clear, the recent move by China Eastern may be a positive message that China's major carriers have started to give foreign investment the green light.
Jane Pan is a Vancouver-based Chinese air transport specialist. She previously worked with Lufthansa and IATA in Beijing