Lois Jones BEIJING & SHANGHAI Still shuddering from Asia's economic crisis, China's aviation industry is restructuring with domestic tie-ups and the home market high on the agenda.

The Hainan Airlines aircraft took off and spread its wings over the sprawling mass of Guangzhou, south China - one of the most populated cities in the world's most populated country. But instead of brimming with passengers, only one traveller was on the flight.

This bewildering contradiction is typical of those plaguing China's troubled airline industry. China is still perceived as potentially the biggest single aviation market in the world, yet half empty aircraft are flying its routes. China needs 1,500 new aircraft over the next 20 years to cope with explosive growth, yet aircraft orders are frozen. The trend is towards consolidation but most airlines shy away from any form of co-operation. China's 39 airlines are drastically cutting costs, yet only four - Xinjiang Airlines, Xiamen Airlines, Sichuan Airlines and Shanghai Airlines - are profitable.

As if that were not enough, airlines are still struggling to overcome the Asian crisis, which sucked dry tourist traffic from South-East Asia. "The crisis has brought horrific loss of revenue. Beijing to Seoul used to be known as the 'Golden Route' for Air China. Now that airlines in South Korea have slashed fares, we're even making a loss of what used to be our most lucrative route," says Yang Bing, manager of Air China's lease financing department.

The Chinese airline industry is trying to adopt four key tactics to help stem losses and bring the industry back into shape: internal reorganisation; discounting; rationalisation and better service.

Once airlines have stemmed losses and restructured they then intend to consolidate. "Air China now wants to merge or consolidate in line with government orders to stop state airlines going bankrupt. Consolidation should take place next year, but first we have to sort out a lot of problems and restructure," says Yang.

The Beijing-based flag carrier has been pushed into merger talks with China Southern, although neither carrier welcomes the move. Talks took place in late June between Air China and the parent of Guangzhou-based China Southern. The State Council is said to have already given approval for a merger in principle.

The merger would effectively float Air China. China Southern has already listed on the New York and Hong Kong stock exchanges in July 1997. Air China announced its intention to list in October 1997, but the impact of the Asian crisis and unhealthy finances stalled the move.

"Privatisation has stopped due to our financial loss and the economic crisis. We set up a special office to handle the listing but then closed it down. It'll be some time before we kick off the privatisation process," says Yang.

Many are surprised by the prospect of a marriage between state-owned Air China and commercially astute China Southern. The only thing they appear to have in common is heavy losses.

China Southern, the most aggressive of China's carriers, made the biggest net loss of any Chinese airline last year. It went $65 million into the red, compared with a net profit of $137 million for 1997. The loss was mainly due to a steep decline in operating profit and large exchange losses. While Air China will not reveal the extent of its losses, it is understood to be around ´2.5 billion for 1998. Yang admits that the carrier can only hope to reduce its losses and will not make a profit by year-end.

A merger of the country's two largest carriers would dramatically reshape China's airline industry and fall in line with the rationalisation plans of the Civil Aviation Administration of China (CAAC). A more consolidated industry should help curb a decade of explosive growth, reduce the numbers of airlines to 10 within the next five years and restore profitability.

"Certainly the trend is towards consolidation. It makes sense to see a lot more mergers and alliances. There are a lot of discussions going on right now about alliances, expected to take place towards the end of this year or in 2000. The strategy is in place, the problem is now putting it into practice," says the aviation official.

For months, rumours within Chinese airline circles have had China Eastern Airlines looking at a take-over of Shenyang-based China Northern Airlines and Xian-based China Northwest Airlines, while China National Aviation (CNAC) has been linked with a take-over of Chengdu-based China Southwest.

Consolidation concerns

Many worry over whether airlines should be consolidated, says C J Wysocki, lawyer at Freshfields, Hong Kong. "The argument for consolidation runs that there are lots of smaller airlines which have synergies with larger ones. The argument against asks why the larger airlines have to take care of smaller airlines and all their problems," he says.

China's first co-operative effort, named the New Star Air Alliance and comprising six provincial carriers led by Hainan Airlines, was formed in September 1997. There has been barely a flicker of consolidation activity since, although Zhou Ming, China Eastern's deputy finance director, says that CNAC (the commercial arm of CAAC) and China Southwest Airlines intend to merge in the near future. The CNAC also owns stakes in Hong Kong-based Dragonair and in Air Macau.

China Eastern is "looking for the next object of acquisition" after sweeping China General Airlines under its wing in late 1998, says Zhou. "We were considering enlarging the group, but have to take into account the not-so-prosperous market. Progress may be slower than expected," he says.

Before consolidation can proceed, airlines need to restructure internally. Heads have started to roll from the top as the CAAC cuts its 400 staff to 250. This is making it more difficult for the CAAC to control its state-owned airlines. "The CAAC says it will take on more of a regulatory role and give the airlines free rein, but they're finding it difficult. The fact that the CAAC has half the staff that it used to have is making the dilemma worse," says the aviation source.

The management cutbacks are permeating to the CAAC's state-owned airlines as Beijing endeavours to make them more commercial, safety-focused and service-orientated. "The CAAC is issuing yellow cards to the chiefs of all airlines that made losses. If that airline makes a loss again this year then the bosses are given a red card and they're out," says the aviation official.

China Eastern's Zhou admits that, "improving the management is the most important thing within China Eastern at the moment. It's the first time that the airline has made a loss and we all feel very bad about that so we're improving the management to cut costs. We're paying more commission and offering financial incentives to marketing and sales personnel to try and improve this side of the business."

Heads roll at Air China

Air China has undergone even more drastic management changes. The former president, Yin Wenlong, was replaced at the start of the year with the airline's new president, Wang Li'an, former president of China Eastern and deputy general managing director of CAAC, taking his place.

Changes are reverberating down the employee hierarchy. "First of all we need to adjust our internal reorganisation," says Yang. "Some internal departments have been shut down and others have been merged. We've put more people into the marketing and sales promotion departments, though."

Around 100-200 temporary workers have also left Air China. "It's not possible to fire people in China, so we just give them non-essential jobs. We want to decrease staff numbers, so we've set up a special department for them. Otherwise we send them to work at an Air China subsidiary or retrain them. They get paid less then before - everyone's salary has been cut by 10%," says Yang.

Other cost-cutting measures include decreasing capacity and cancelling routes; and selling old aircraft and real estate, says Yang. Air China employees are moving out of the carrier's head office building in central Beijing and into an office near the airport before the carrier sells the city office. The airline has also cancelled "non-essential" flights, such as Beijing to New York, and plans to cancel more soon, says Yang.

Air China is not the only Chinese airline to cancel routes - CAAC plans to cut domestic flights by 5% to boost profits across the industry. "The new schedule, which took effect on 1 May, cut 92,792 seats and 766 flights from 15 airlines," says Liu Xueqing, director of CAAC's flight division.

Demand within China is lacklustre - in the first quarter, domestic passenger traffic rose by 3.5% year on year. However, traffic on international routes and services to Hong Kong shot up by 21% and 22% respectively, says Ding Yuem, CAAC's director of statistics division.

In response to falling domestic demand and overcapacity, Chinese airlines are leasing out aircraft. In January, the CAAC banned new aircraft orders until 2000, and ordered airlines to reduce overcapacity by not renewing aircraft leases and selling other aircraft.

Airlines have responded to the CAAC's order by signing wet-lease deals, ordering replacement rather than new aircraft this year and confirming options, says the aviation source. "The last decade's 12% growth rate has dropped to 7% in the last two years to around 6% this year. But that still means growth and still means a need for more aircraft," the source says.

Yang admits that Air China plans to "sell some secondhand aircraft, probably Boeing 747s, cargo Lockheed Martin C-130s in August or September this year". The airline also plans to put three Boeing 777-200s and three Airbus A340-300s on the market for dry lease.

Yang says Air China is looking at short-haul aircraft. "We lack small aircraft such as Airbus A320s or A319s. Several banks, such as Chase Manhattan, have offered us long-term financing for aircraft purchases. US Eximbank has guaranteed Boeing 737-800s for 1999. We may introduce four 737-800s this year as well." The airline is awaiting government approval for orders for seven 737-800s and for eight A318s.

China Southern, meanwhile, means to wet-lease two 777-200s. In April, China Eastern sealed a contract with Gecas to dispose of its ageing Boeing MD-82s in the next two years. China Eastern plans to introduce three new A320s, two MD-90s and exchange Fokker 100s with five A320s this year.

All Chinese airlines are trying to get rid of their Soviet-built Tupolevs following the fatal crash of a China Southwest Airlines' Tu-154 off the east coast.

Chinese airlines' focus on narrow-bodied, single-aisle aircraft reflects their emphasis on the domestic, rather than the international. "Where China is hurting is on long-distance routes where traffic has dropped," says an aviation source, referring to falling yields.

"Air China is looking more at domestic, rather than international routes, where the potential for profit still exists. We need to expand the domestic market," says Zhou. The carrier is considering new routes to Guangzhou and Xian.

A ban on domestic fare discounting means that passenger turnover for airlines such as China Eastern has fallen by about 20%. Domestic revenue accounts for around 40% of China Eastern's turnover, with revenue from international and Hong Kong services making up the remainder.

"Passenger turnover has decreased 20% at the current level, but we believe that the authorities will take the necessary measures to make the situation improve. The price of air tickets should be varied according to different seasons and times of the day so we believe that the policy should be more flexible. We hope that this will happen in the second half of this year," says Xia Yi, China Eastern's deputy chief accountant.

China Eastern looks west

China Eastern has some international ambitions for the immediate future and hopes to launch a new service to London next year, using an A340. It will increase weekly US frequencies from 21 to 54 within the next three years.

The carrier also intends to conclude its codeshare with Qantas this year, to add to codeshares with American Airlines, Korean and All Nippon Airways. As for Europe, China Eastern says it is in contact with European airlines, including British Airways, Lufthansa and Air France, with a view to future co-operation and a subsequent alliance.

"We have routes to Germany, France, Spain and soon to the UK ,so we are considering co-operation with these countries' airlines. But as yet we have not decided where to put our emphasis in Europe. London is a very large market and will always be attractive to us but there are not enough slots. Belgium is the political heart of Europe but is not large enough. As for Germany, we already fly to Munich, but the centre seems to have transferred to the north, so we hope to extend our flight to Frankfurt," says Xia Yi, China Eastern's deputy chief accountant.

The airline is moving towards closer ties with western companies. Last year it established China Cargo Airlines, a joint venture with US-owned China Ocean Shipping Company - the first ever US-Chinese carrier, says Zhou.

But China remains cautious. In the opinion of the Chinese aviation source, China would not welcome a multilateral approach from Europe because "Chinese airlines like to fight one European country off against each other and prefer to deal with each member state individually". This is understandable given the problems Chinese airlines face when competing with foreign carriers.

"Chinese airlines cannot see a way of competing - almost everyone, including Chinese, prefers to fly with British Airways to London," says one official.

China may not be ready to open its doors to the west, but the western carriers are ready to come in. The world's airlines are queuing up at the door, bullish about their prospects and waiting to wreck havoc in this fragile China shop. China's airlines, meanwhile, are stalling eager customers, more concerned about sorting out their own affairs before letting in interested customers.

"The main preoccupation of Chinese airlines is still domestic," says Martin Assmann, director marketing and sales at Ameco Beijing. China Eastern's Zhou agrees. "We're interested in domestic alliances first. Several global groupings have invited us to join them, but we haven't decided which to join yet." It is clearly too early for Chinese airlines to join global alliances. "These groupings are all about global access and Chinese airlines could not really add international routes, only access to Chinese routes," says the Beijing aviation official.

The world's airlines will certainly be eager to enter the market when Chinese airlines beckon. It's all just a question of time. As Air China's Zhou points out: "The market is huge - and this is just the beginning."

Chinese airlines' traffic growth 1998

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Source: CAAC

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China international



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*Includes 16 routes to Hong Kong source: CAAC, ICAO

Chinese passenger traffic compared

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Source: International Air Traffic Association All figures are forecasts

Source: Airline Business