The People's Republic is overflowing with airlines, but in the wake of the Asian crisis, few are turning a profit

Chris Jasper/LONDON

Though Beijing, in the form of the Civil Aviation Administration of China (CAAC), has been talking up the prospect of consolidation within the country's airline industry for some years, few observers were prepared to take seriously the possibility of a major reorganisation until recently. And then the unthinkable happened: industry sources within China insisted that the Chinese Government was contemplating a forced merger of the country's two largest carriers, China Southern Airlines and Air China.

The merger talks were reported in Flight International and soon appeared in the Hong Kong press, forcing China Southern - a company listed on both the Hong Kong and New York stock exchanges - to either deny or confirm them. To much astonishment, the Guangzhou-based airline requested that trading in its shares be suspended - and then declared that the reports were true.

The incredulity that greeted that announcement - one Hong Kong analyst claimed that a merger would be "a crazy transaction" - reflected the apparently poor fit between the two airlines. But at the same time it also revealed just how concerned Beijing has become about the ramshackle nature of China's airline industry.

The country's 30-plus airlines suffered a combined loss of more than 6 billion yuan ($725 million) in 1998 according to official sources, with all but four carriers (stock exchange listed Hainan Airlines and Shanghai Airlines, plus Shenzhen Airlines and Sichuan Airlines) finishing the year in the red. During Asia's boom years, the unwieldy nature of the airline network was easy to ignore as carriers reported impressive growth figures, but with losses mounting due to the sharp decline in the Asian travel market, Beijing was forced to act.

Draconian moves were announced by CAAC in January with airlines instructed to scrap discounting (ending a fares war that broke out last year as the market shrank) and a moratorium on new aircraft purchases and lease extensions. CAAC also stated that the number of Chinese carriers should be reduced, but its commitment to structural change was revealed only when the China Southern/Air China machinations became public knowledge in June.

The Chinese industry is a relic of the splintering of CAAC (in its previous guise as an umbrella company) into Air China, China Eastern, China Northern, China Northwest, China Southern, China Southwest and China Xinjiang in the late 1980s. Provincial governments were subsequently allowed to establish their own carriers in a move intended to liberalise the market, but which led to a proliferation of unsustainably small airlines.

A merger between flag-carrier Air China and market leader China Southern would clearly do little to help consolidation lower down the Chinese hierarchy, and is apparently aimed at securing a 'back door' stock market listing for the former. Air China has been looking at floating for two years, but given its parlous financial state would be unable to make such a move under its own steam.

China Southern will say only that it has had "preliminary discussions" with Air China "which may or may not lead to a strategic relationship, including, without limitation, a merger". But while such a move could take two years or more to complete given the huge differences between the two (not least in terms of geography, the pair being 2,000km apart), China's State Council is reportedly driving the plan, with Air China keen to see it go through and China Southern rather less so.

If the merger does happen, analysts believe it could force flash mergers among competitors. China's third largest carrier, China Eastern, which is also Hong Kong and New York listed, has been linked to possible mergers with China Northern and China Northwest. However, sources at the airline tell Flight International that it is reluctant to become involved in a forced consolidation, and is still suffering the after-effects of absorbing Taiyuan-based China General Aviation in 1997, with rationalisation moves resisted by provincial politicians.

Other mooted take-overs would link the Zhejiang Airlines subsidiary of China National Aviation (CNAC), the country's flag-carrier until 1949 and re-established in 1995 as a holding company, with China Southwest. CNAC is itself Hong Kong and New York listed and holds a 51% stake in Air Macau and a 43% stake in Dragonair, having won control of the Hong Kong regional from Cathay Pacific and mainland rival CITIC Pacific in 1996.

Whether or not China's various merger scenarios are ever played out may depend on how quickly the country's aviation sector recovers from the Asian collapse. China itself escaped the worst of the crisis, mainly because it is not fully exposed to the fluctuations of international markets. The airline sector, however, is an exception to this rule in that it was badly hit by the fall in demand for both business and leisure travel to other Asian countries.

Following January's austerity moves by CAAC, the industry is at least beginning to show some signs of recovery, although the picture is patchy. Beijing newspapers, quoting CAAC sources, say China's airlines made a loss of 820 million yuan in the first half of this year, more than 40% better than the 1.42 billion yuan loss for the same period last year.

Much of the improvement has been attributed to the ban on discounting - although this could delay the recovery of leisure traffic - and to the promotion of a new 'Fly China' policy.

Other quoted figures suggest the six months saw overall passenger volume grow by 2.6% (to 27.59 million emplanements for the period) and cargo tonnage by more than 20%. The biggest rebound has been on international routes and services to Hong Kong and Macau, with domestic recovery much more modest.

Most significantly, China Southern and China Eastern both reversed losses suffered in the first half of 1998, although the latter's net profit was modest. Air China does not release net result data, but is thought to have taken further losses, albeit not as heavy as last year. CNAC-Zhejiang reportedly returned to profit, while China Northwest cut its losses. Airlines profitable in the first half of last year - including Shanghai, Shenzhen, Xiamen, Xinjiang and Yunnan - remained in the black, although a sixth, Hainan, saw net profits fall 14%. In Hong Kong, once thriving Dragonair saw a 50% drop in operating profit on increased turnover, based on CNAC receipts, complaining of declining yields and increased charges on new aircraft.

China Southern, though, says "the results relect the improvement in the operating environment from the recovery of Asian economies, and our continuous effort to strengthen competitiveness by tightening cost control".

As it weighs up its options for restructuring, one major consideration for Beijing is the impact of consolidation on the alliance options of its major airlines. Currently, Air China is close to the Wings group via its codeshare with Northwest Airlines, while China Southern has a similar deal with Delta Air Lines, soon to launch a global alliance with partner Air France.

China Eastern has a foot in the same camp through a codeshare with the French carrier, and is also linked to oneworld airlines American and Qantas, as well as Star Alliance recruit All Nippon Airways. Sources say it is keen to pursue global alliance ambitions as an alternative to domestic consolidation. Dragonair, meanwhile, is expected to sign up to oneworld. Should the number of Chinese carriers be reduced, however, the scope for representation across the various alliances could clearly be compromised.

China has also been forced to review its aircraft fleet planning in the wake of the downturn. CAAC restrictions ban the renewal of most leases and require the disposal of aircraft excess to requirements. New purchases have at the same time been outlawed this year, although some carriers seem to have got round the ruling.

Hard-hit Air China is planning to lease three Airbus A340-300s to Hong Kong heavyweight Cathay Pacific, which already operates 11 of the type. Cathay - which continues to operate independently of Beijing - has itself sold five ageing Boeing 747-300s (the last of 13 747-200/300s) and has deferred some orders while adding two 777-300s. Air China is also offering around 777-200s for long-term dry lease.

Dragonair has also disposed of aircraft, leasing an Airbus A320 narrowbody to TransAsia for the summer and returning an A330 widebody to International Lease Finance (ILFC) earlier than planned.

China Eastern's approach has been to defer the arrival of shorthaul airliners (pushing back delivery of 10 A320s from China's centrally ordered pool by a year) while signing a letter of intent with ILFC for Airbus A340-500/600s to replace Boeing MD-11s due to be converted to cargo use.

Hainan Airlines, in contrast to most other Chinese carriers, is aggressively growth minded and has added three Boing 737-800s and a 737-400, following up last month with an unexpected firm order for 19 Fairchild Aerospace 328JETs, side-stepping the CAAC ban, which apparently applies only to aircraft of 100 seats and above. The carrier is raising 200 million yuan from a share sale, has credit lines worth nearly 6.75 billion yuan, and is audaciously seeking international rights.

Airlines have also been forced to rein in their route networks, with the most spectacular move being China Southwest's scrapping of a new weekly A340 service to New Zealand from its Chengdu base (via Guangzhou or Shanghai) after just one month. Dragonair this year dropped routes from its Hong Kong base to Ningbo and Tianjin, but is planning to add Shantou and Sanya, plus overseas destinations. The airline has rights for 40 mainland cities, but currently serves just 16. China Northwest and China Cargo Airlines are favourites to be selected as new designated carriers on US services commencing April 2001.

Despite recent setbacks, the overall outlook for Chinese aviation remains optimistic. The world's most populous country is on course to become the world's largest economy over the next three decades, and demand for travel is expected to increase exponentially. The question for China is whether its airline sector will put current agonies behind it and move forward as a leaner, more competitive industry, or whether it will remain hamstrung by regional and political considerations.

Source: Flight International