Flying High: China's aviation industry is becoming a global force

Image: Kim Kyung Hoon / Reuters

Since the beginning of China’s economic reforms in 1979, domestic air travel in China has risen from nothing to become a huge and booming industry. But now China’s airlines are spreading their wings even wider and becoming major players on air routes around the world.

In 1982, there were less than 4 million air passenger journeys in China, according to the Civil Aviation Administration of China—by 2016 that number had reached 487 million. That same year, 133 million Chinese tourists traveled abroad, quadruple the number going overseas a decade earlier. It’s a change that can be easily seen at airports anywhere in the world.

“Even around six or seven years ago, around 70% to 80% of passengers in the [US-China] market were American,” says Dr. Zheng Lei, Founder and President of the Institute for Aviation Research, an independent think tank based in the UK, and Director of the Centre for Aviation Research at the University of Surrey. “Now more than 50% of travelers are Chinese.”

The pace of the Chinese airlines muscling into new territories is speeding up. New intercontinental routes opened by Chinese carriers in 2006 numbered just six, while from 2014-17, the number was more than 50, according to the CAPA Centre for Aviation , an industry news portal. By 2029 China is expected to overtake the United States as the world’s largest passenger market, which includes travelers going to, from and within the country—although China already schedules more flights to the US than the other way around, with Chinese carriers operating about 10% more flights between the two countries than their US counterparts in 2015.

What was once out of reach for most Chinese people, is now standard for many.

“Before, traveling by air was a luxury… If you were traveling by air you were successful,” says Shen Pingping, a 34-year-old entrepreneur in Shanghai. “Now [average] people travel at least once a year.”

But China’s lofty success has brought with it some serious challenges. China’s domestic aviation infrastructure, for example, is struggling to keep up with growth in air traffic demand. This has led to lengthy delays that are so common they sometimes seem to define air travel in China over the level of quality and affordability. These problems of capacity are also more than just domestic because they affect other international carriers, and the bilateral air service agreements that China strikes with other countries. This will be important for continued expansion, as Chinese airlines are not as global and profitable as their counterparts in other nations.

Additionally, although Chinese airlines have achieved enviable success, China has not yet been able to construct its own commercially successful airliners. As a question of international prestige, this is an absolute must.

However, in terms of market share and potential, Chinese airlines have the wind at their tails. The rest of the story may just be persistence and time.

Zero to 30,000 feet
Perhaps more than any other industry, commercial aviation places the safety premium far above profitability and customer service. According to The Wall Street Journal, Chinese airlines in the 1990s were among the world’s most dangerous, “beset by persistent pilot errors, unreliable maintenance and erratic government oversight.”

In this most basic area alone, China’s progress has been a triumph.

“I first came to China in ’96, and at the time I refused to fly on any Chinese airlines because I wasn’t comfortable [with the level of safety],” says Shukor Yusof, founder of the Singapore-based aviation industry advisory, Endau Analytics. “Now I wouldn’t have any qualms at all.”

Following a massive industry overhaul in the early 2000s, many of China’s airlines consistently rank among the world’s safest. Safety has become such the priority of the Civil Aviation Administration of China (CAAC) that Zheng Lei says standards may even be too high, restricting the number flights that airports are allowed to handle.

But the real story is that of the mass consumer move to air travel. Set next to one another, growth in China’s disposable income tracks neatly with the rise in passenger traffic. Not surprisingly, most Chinese people prefer to fly on Chinese planes internationally as well as domestically. The growth in passenger numbers has been phenomenal, with the market growing at annual rate of more than 15% for over a decade. In terms of passengers carried, China’s big three state-owned carriers are all in the world’s top ten. And they’re doing better financially as well.

“Previously Chinese airlines have lost a lot of money,” says Zheng Lei. “Now they are making [it].”

Driven by the opportunity, China has seen a proliferation of private airlines, which has had a tremendously positive competitive effect on the industry.

“From 2010 onwards, you have seen a transformation in [Chinese airlines] in their ability to introduce better products,” says Yusof.

Some of this is at the top end. Hainan Airlines, operating out of the eponymous southern island famed as a vacation spot, has achieved a Skytrax five-star airline ranking. There are only nine of them in the world, and none from the United States.

But expansion of service offerings has come at the low end as well, and this has arguably had the bigger impact as it helps pull in more fliers. Spring Airlines, founded in 2004, has been a leader in this new category of very-low-budget airlines, beating the unit operating costs of China’s big three by 35%, enabling Spring to offer rock-bottom prices. While the market share of these budget airlines is still small in China, 9% compared to 56% in ASEAN nations and 40% in Western Europe, growth is robust.

However, domestic passenger growth is starting to slow down noticeably, clocking about 11% annually since 2014, according to Zheng Lei. The real action is in China’s newly affluent international travelers.

Around the World
“If you start traveling it is like an addiction,” says Shen Pingping, who in the past few years has racked up trips to India, Europe and North America. “You go somewhere close, then you want to fly somewhere further.”

Infections by the travel bug, it seems, are quickly approaching pandemic level—Chinese international passengers grew by 33% in 2015 and another 28% in 2016. While this remains only about 7% of total traffic of Chinese airlines, it still amounts to tens of millions of flights. During the recent 2017 Spring Festival alone, more than six million Chinese people vacationed abroad.

Shen says it reflects both an increase in the amount of spending money people have, but also a broad cultural change. People are just not content to sit at home anymore for Chinese New Year eating and drinking for days on end—it gets boring. Folks want to strike out for new frontiers.

Fortunately for Chinese airlines people only change so much, and so are in a prime position to take advantage of the opportunity.

“Chinese airlines have the advantage with Chinese passengers… they know the customers better,” says Zheng. “That really helps them in the international market.”

The impact of this advantage is tangible. In 2015, China overtook the US for the first time in the number of flights scheduled between the two countries. By December of 2016, the gap had widened to 781 flights by Chinese carriers versus 596 for US airlines, in terms of direct flights only.

But despite edging ahead of the US on these routes, overall Chinese carriers are nowhere near as large, global and profitable as US airlines. In 2015, the top four most profitable airlines in the world were all US, with a combined profit of $15.7 billion dollars—taking the top spot, American Airlines managed $6.09 billion on its own. By contrast, the only Chinese airline to make the top ten was Air China, turning a respectable $1.09 billion profit.

Part of this has to do with how truly global US players are, as compared to Chinese airlines. Air China has a fleet of about 400 planes, and flies to over 200 destinations worldwide. Again using American Airlines as the measuring stick, it has a fleet over 900 planes and flies to about 350 destinations. It is also noteworthy that Chinese airlines operate fewer of the large international planes, like the Boeing 747, than other big world carriers. United Airlines has 21 of the jetliners, Air China just 9.

However, another interesting comparison is Emirates, which has its home in Dubai. Despite having a smaller fleet size, about 250 planes, and fewer destinations, about 140, it still manages to be more profitable, bringing in $1.57 billion in 2015.

Regionally, the emergence of Chinese airlines is having a huge effect on the marketplace.

“The proliferation of Chinese carriers, the increasing number of flights, the number of aircraft they put into their fleet, has heavily eroded the profitability of Cathay Pacific,” says Yusof. The Hong Kong-based carrier’s net income dropped by 82% in the first six months of 2016.

But Chinese tourists are famous for the amounts of money they spend on vacation, which reached $215 billion in 2015. This power of the purse has countries changing their bilateral air service agreements with China—these agreements govern the number of commercial flights allowed between two countries and are negotiated between governments. Last October, Britain agreed to double the number of Chinese passenger flights allowed each week to 100. Not long after in December, Australia lifted all restrictions, allowing unlimited flights between the two countries.

But not all is roses in bilateral agreements. According to Reuters, negotiations for more flights between the US and China broke down in late 2015 due to US concern that they would not be given adequate slots at Chinese airports.

“Chinese carriers can benefit from the growing market while US carriers cannot,” Zheng Lei says.

Yusof concurs saying that a lot more flights should be going from the US to China but that’s not happening because it is still not very easy for foreign carriers to enter into the Chinese market.

But while this is in part a political issue between the two great powers, it is also very much an infrastructure issue on the Chinese side. US carriers worry about airport slots because China just does not have enough.

Too Close to the Sun
“The number of airports in China is not representative of a country where aviation is the fastest growing industry in the world,” Yusof says.

China is working very hard on this problem, adding eight airports last year for a total of 210. The United States has 330 airports considering a population that’s only one-quarter the size. That’s one significant reason there are never enough slots for foreign carriers in China.

Zheng Lei says “US carriers are now waiting to see Beijing’s second airport open” before figuring out how to proceed. According to the CAAC, the government is spending RMB 80 billion on the facility, which will be able to handle an annual passenger turnover of 72 million. Carriers will have to wait until 2019 for it to open, though.

Of course foreign airlines are far from the only parties affected by the underbuilt nature of China’s airports—the Chinese public bears the daily pain of seemingly constant delays, which have a way of turning people away from air travel altogether.

“Travelling domestically, we prefer to take the train,” says Shen, noting the cost parity, the time parity when everything is factored in, the superior comfort and most importantly the rock-solid reliability of China’s train schedules. “If I go for a business trip I would way rather take a train to make sure I arrive on time,” she adds.

Indeed, China’s high-speed trains carry more than double the number of passengers each month as its airlines. Moreover, the CAAC noted that pressure from high-speed rail has caused passengers on routes around 500 km to be cut in half. Some airlines have even shut down their shorter routes.

Another problem has been a massive shortage of experienced pilots, which has some carriers offering annual salaries of $300,000 to attract veterans from foreign airlines. However, this problem will be solved in due time. There are plenty of quality co-pilots in China coming from its two primary air schools, but they do not have the experience to qualify as captains and it is impossible to shortcut that problem.

A more complex and important issue, however, is that China has not yet developed adequate “hub-and-spoke” operations, which affects air alliances and code sharing. Beijing, Shanghai and Guangzhou each have large hub airports, but their geographic situations are not conducive to transferring traffic to and from Europe, for example, which affects how airlines are able to funnel traffic to one another.

“Looking at the map of China, it does not make sense for people in Urumqi [in China’s far northwest] to come back to Beijing and then fly to Europe,” says a source in CAAC’s international department. But China’s population means that big regional airports certainly have a base. “[The central province of] Henan has 100 million people. That’s the population of a mid-sized country in Europe, there is potential to support air travel.”

However, part of the problem may be ‘regionalism’ on the part of provinces that keeps them flying point-to-point with international carriers in the hope of driving tourist dollars. So instead of developing hubs and air alliances, local governments offer subsidies.

“Chengdu gave British Airways (BA) these subsidies and it lasted for three years,” says Zheng, describing the BA Heathrow-Chengdu route. “It expired last year and BA stopped the route.”

In Zheng’s view this is a very serious issue because airlines are necessarily a network industry, particularly at the international level. If you don’t have airlines in your network funneling traffic, then routes are not sustainable. While China’s big three state-owned airlines are in major international air alliances, many of China’s smaller airlines are not. Even Hainan Airlines, with its coveted five-star rating is not in an alliance, although one has recently been proposed by Virgin Australia.

“The next five years will be the last opportunity for the Chinese airlines,” Zheng says. “If they are not able to develop their functioning hub-and-spoke system, they may lose out.”

Airliners
China is not content simply to have thriving airlines, it also wants to be a player in airliners.

“When you want to be a superpower, you have to be involved in aircraft manufacturing,” says Yusof.

For China, having a competitive aircraft manufacturer is of course about national honor, but it is also a strategic business position. China is far and away the world’s largest market for aircraft, and China is virtually entirely dependent on the duopoly of Boeing and Airbus. Boeing predicts that China will buy $1 trillion worth of planes over the next 20 years.

Again, you can’t knock China for lack of effort in this field—building a viable commercial airliner has been a decades-long pursuit in China. The Commercial Aircraft Corporation of China (COMAC) finally managed to introduce the ARJ21 jet into service in June of last year, ten years behind schedule. And although the jet is touted as a domestic achievement, it still relies heavily on foreign expertise and components. The wings, for example, were designed by the Ukrainian firm Antonov State, and the engines are from General Electric. (COMAC is also working on the larger C919, which just made its first test flight in April.)

Commercially, the ARJ21 leaves a lot to be desired. Unsurprisingly, orders have mainly come from China’s state-owned airlines, and even there they will be but a small part of fleets. Providing serious competition for the likes of Boeing and Airbus in the Chinese market, let alone the international market, is for the time being out of the question.

“Boeing has been around for more than 100 years. It is tried and tested,” says Yusof, who explains that he does not harbor too many doubts about the quality of the ARJ21, but rather sees a problem in a business that hinges on reliability and safety.

In his native Singapore, Yusof says he witnessed the arrival of Chinese manufactured cars some years ago, which initially flooded the market, but then disappeared within just a few years.

“The perception is, rightly or wrongly, that they don’t make good cars,” he says. “In an aircraft, you don’t want to take any chances.”

However, like many issues facing the emerging aviation industry in China, this is also likely to be resolved given enough time and steady effort. It even took Airbus, which was founded in 1970, many years to be truly competitive with Boeing. Chinese aircraft will similarly take another 10 or 20 years to start making a real dent in the competition. In the grand scheme of things, the debut of Chinese aircraft is likely intended in the first phase simply to build confidence in the safety of Chinese planes.

Cruising Altitude
While the main obstacles to the continued development of China’s aviation industry are significant, one needs to consider the full picture of China’s aviation development. In the space of a few decades, commercial flight in China rose from being negligible to a force so big that it is starting to change the global marketplace.

Moreover, meeting challenges such as the shortage of airports and pilots and the trials of making some of the world’s most complex machines safe and commercially viable is mainly a matter of sustained effort. And of that there is plenty.

“They are in it for the long haul,” says Yusof.

The most important factor is still the size of market. Barring a truly extreme economic catastrophe, demand for Chinese flights domestically and its share of global air routes will only grow. The sky is, literally, the limit.

[This article has been reproduced with permission from CKGSB Knowledge, the online research journal of the Cheung Kong Graduate School of Business (CKGSB), China's leading independent business school. For more articles on China business strategy, please visit CKGSB Knowledge.]