For more than a year we knew it was coming but now the 2011 Aircraft Sector Understanding (ASU) has started to take effect, everyone is still wondering how it will change the most widely used form of aircraft finance - export credit - and the potential repercussions of these changes.
The new ASU - replacing a 2007 agreement - comes at a time when traditional sources of commercial financing are stressed and airlines and lessors are relying more on export credit to finance new aircraft. The higher fees expected under this ASU could bring a hefty lift in financing costs for many airlines, which in turn raises questions about how these changes may affect aircraft financing and purchase patterns over the longer term.
The 2011 ASU addresses most of the issues that prompted its adoption by the Organisation for Economic Co-operation and Development (OECD). Airlines in the USA and parts of Europe which did not qualify for export credit because of a so-called "home market" or "home country" rule, complained loudly that strong rivals such as Emirates were gaining an unfair advantage - many called it a subsidy - because those carriers were not in a "home" country and so could access cheaper export credit.
Another group led by Emirates, Etihad and Ryanair responded that a better solution would be to scrap the home country rule so export credit was equally available to everyone. While this debate raged, Airbus and Boeing worried that manufacturers in Brazil, Canada, China, Japan, and Russia were building or planning larger aircraft, and the export credit for those aircraft ought to be under the same rules as for US and European-built aircraft.
Dean Gerber, partner at Chicago law firm Vedder Price and chair of its global transportation finance team, has watched developments closely. He recalls the arguments "united rival manufacturers and pitted airlines and commercial banks against governments in a dispute over the role ECAs [export credit agencies] play in supporting sales of commercial aircraft".
The 2011 ASU applies to all new commercial aircraft, except regional jets and turboprops, delivered since the turn of the year. New regional aircraft come under the agreement on 1 January 2014. It applies to new aircraft from all manufacturers except those in China and Russia, which are not OECD members. Brazil is not an OECD member either but has accepted the new ASU. Aside from this difference in effective dates, the ASU eliminates all distinctions between aircraft type and sizes.
The new ASU raises the export credit premium for all buyers/borrowers, whether airline or lessor, but the rise is steeper for those with a better credit rating. Higher-risk airlines will still pay more than they do now but not as much proportionally, making export credit less attractive to stronger airlines. As Gerber explains, the accord "attempts to bring ECA financings more in line with market conditions". By including new aircraft from Canada, Brazil, and Japan, Gerber says the ASU will also "minimise the support of the ECAs as a factor in the choice by buyers/borrowers among competing aircraft".
The new ASU directs each export credit agency to classify its buyers/borrowers into one of eight risk categories, based on their senior unsecured credit ratings. These rankings, valid for up to 12 months, will be recorded with the OECD Secretariat.
An airline's risk rating affects several things, the main one being the amount of premium an ECA will charge for providing export credit. Calculation of this premium is complex, but it starts with an airline's risk rating. Once the premium is calculated for a given transaction, it is set. The customer may pay it up front or during the life of its loan. Questions remain about whether the premium itself may be financed.
Export credit agencies will adjust their premiums prospectively. They will set the new premiums each February and adjust them quarterly through surcharges. The purpose of these adjustments is to keep premiums in line with changing market conditions. As a result, premiums may rise or fall but insiders say they will not change as sharply as the market itself. As one banker puts it, these adjustments seek a balance between stability on the one hand and keeping pace with the market on the other.
Risk ratings affect other things as well. ECAs may cover up to 85% of the net price for higher risk airlines, but the cover for stronger airlines is limited to 80%. This is another feature, says Gerber, "designed to make ECA financing less desirable for these buyers/borrowers who can more readily access commercial financing".
Most observers predict such disincentives will drive financially strong airlines away from export credit. This is precisely the intended consequence, with the result, of course, that it will leave the ECAs exposed to higher risks.
However, the ASU drafters added requirements to reduce this risk. Export credit for higher risk airlines comes with more strings attached. These may include higher initial security deposits, shorter repayment periods, minimum lease payments for leased aircraft, and higher maintenance reserves.
Regardless of risk rating, all transactions must also be asset-backed, with protections for the lender and ECA in the form of cross-default and cross-collateralisation of all aircraft and engines owned by the same buyer/borrower, plus special creditor and guarantor protections in the case of leased aircraft.
The ASU also uses a carrot-stick approach to encourage nations to adopt the Convention on International Interests in Mobile Equipment and its related Aircraft Protocol, collectively called the Cape Town Convention. This carefully crafted law creates an international registry of security interests in aircraft and spells out creditor rights, thereby eliminating much of the uncertainty about how creditors might fare in a local jurisdiction after an air carrier's default or insolvency. The airlines of any country that adopts the Cape Town Convention, making it the law of their own land, qualify for a discount of up to 10% on their export credit premium.
So far, 52 nations have adopted the Cape Town Convention and several more, including Australia and Canada, seem anxious to follow suit. The so-called "Cape Town discount" no doubt gives them an added incentive. Australia's transport minister Anthony Albanese estimates that adopting the convention will save Australian airlines, which routinely use export credit, $330,000 on a new ATR 72 turboprop and $2.5 million on an Airbus A380.
How much will these new rules add to the cost of export credit? "The 2011 ASU roughly doubles premiums contained in the 2007 ASU," says Gerber. The minimum premium for an investment-grade airline will rise from about 4% of the transaction value to almost 8%. For lower-rated airlines, the new premiums will be higher. Airlines in any country which adopts the Cape Town Convention will qualify for that discount.
Higher-risk airlines will continue to rely on export credit because they have nowhere else to go, but stronger airlines with access to commercial financing may find export credit less attractive. This is the underlying goal of the new ASU.
Predictions differ on the likely collateral effects. Among the more optimistic are those who foresee a boost to commercial lenders. Until now, many lenders have shunned the aircraft sector because of the lower rates offered on ECA-backed loans. The recent popularity of export credit, they claim, has distorted the market. Higher interest rates, so the theory goes, will attract more financiers into the sector. Some even predict such increased competition between lenders will bring commercial rates down.
The shorter-term view is less rosy. Commercial liquidity is still limited for reasons that have little to do with airlines. The more pessimistic predictions are that this shortage will compel continued reliance on export credit, even by investment-grade airlines, with the aircraft manufacturers themselves stepping up with more support.
Experts debated the ASU's effect at a conference of the International Society of Transport Aircraft Trading in September. Kostya Zolotusky, managing director of Boeing Capital, predicted that because of higher financing costs, "we will see more people rent than buy aircraft".
Ray Sisson, president of operating lessor AWAS, agrees but also thinks the new ASU will cause carriers to defer orders for new equipment, saying: "It will drive more airlines to older aircraft."
We will soon see whether these new rules cause the slump in aircraft finance some predict, but even the naysayers acknowledge airlines and lessors will eventually adapt to the higher cost of aircraft finance, whether through export credit or commercial loans, because they have little choice.
One of the few options is the capital market, which may be a viable choice for some. Finnair, for instance, recently raised €120 million ($159 million) in an over-subscribed bond issue, and AirAsia X is optimistic that in the first quarter of 2013 it will successfully raise M$760 million ($250 million) from its initial public offering. However, the capital markets are still an option reserved for stronger airlines under favourable conditions.
Home country rule
The elephant in the room the new ASU does not address is the home market or home country rule, which provoked the loudest arguments preceding the agreement. This rule, which withheld export credit from US and some European carriers, tilted the system, they claimed, in favour of rivals in other countries who could and did take advantage of export credit. But the OECD rejected the suggestion from Emirates and its allies simply to change or scrap the home country rule and settled instead on higher export credit premiums.
One reason for the OECD's approach is that the home country rule is hardly a "rule" in the traditional sense, but rather an unwritten, informal understanding between the USA's Ex-Im bank - and its counterpart export credit agencies in the UK, France, Germany and Spain - that they will not offer export credit to airlines in their own or each other's countries. Skirting around this rule may have temporarily averted a showdown but the unresolved issue of Canada and, by extension, Brazil and Japan, remains potent.
As Gerber explains: "In the past, Canada's primary aircraft manufacturer, Bombardier, did not produce aircraft that directly competed [with Airbus and Boeing]." Canada was not subject to the Home Country rule, so Ex-Im bank and the European ECAs routinely covered aircraft purchases by Air Canada and WestJet. But Bombardier's introduction of the 110/130-seat, twin-turbofan CSeries caused Boeing and Airbus to question why the home country rule should not extend to Canada. "With potential competitors from other countries such as Brazil, China and Russia on the verge of producing similar aircraft to the CSeries," Gerber explains, "Airbus and Boeing were concerned that if Canada was not bound by the home country rule, these other countries would expect identical treatment."
The issue remains unresolved, prompting Gerber to predict that if Canada offers export credit on a CSeries order by a US or European airline, "there may be repercussions in the form of matched home-country financing by the USA and/or the European ECAs". An Air France official already warns that it may test the rule by applying for export credit on its own orders. If the home country rule starts to unravel, then Gerber foresees that the 2011 ASU, to put it mildly, may be open to "further negotiations".
The new ASU clearly has not solved all problems. The immediate future of Ex-Im bank has been secured with its re-authorisation, but by a sharply-divided Congress. This new law directs the US treasury secretary to negotiate with foreign counterparts on ways to reduce export credit generally and, specifically, on aircraft.
As late as November, Delta Air Lines was complaining that Ex-Im bank's cover on a sale of Boeing 787s to LOT Polish Airlines was an "unnecessary subsidy". If such complaints continue now the new ASU has taken effect, or if the home country rule erupts into a full-blown dispute, the 2011 ASU may come under fire well before its scheduled review in 2015.