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The Next Big Boom in Civil Aviation: A study of the constantly changing airline industry in China

Preface

The airline industry has been an interest and a passion of mine since I was a young child. Growing up in New York, I was able to experience, first hand, some major developments in the industry. I was there when the Pan Am Building became the Met Life Building; “World’s most experienced airline” ceased operations in the early 1990s. New York was Pan Am’s main hub city and world headquarters for decades; the airline was brought down after fighting to survive for over a decade following deregulation.

New York has also been home to many airline industry experiments during my lifetime. I remember taking flights on TowerAir during the 1990s; TowerAir began service from New York shortly after deregulation. With a fleet made up entirely of old 747s, packed with as many economy seats as could fit, TowerAir operated short-haul, and intercontinental flights with “no-frills” service. This airline eventually failed after it gained a reputation for putting profit before safety. Around the time TowerAir ceased operations, JetBlue Airways initiated operations from New York. JetBlue’s approach to cost-savings differed from TowerAir, as JetBlue set out to provide service while keeping its passengers interests in high regard. JetBlue is still thriving today.

My experiences with the airline industry from living in New York are valuable; New York is a very competitive market for airlines and success does not come easily, if at all. The airline industry in the United States, in general, is very mature and established, and still, lessons continue to be learned.

This paper is an investigation of the airline industry in the US in order to better understand the airline industry in China. More specifically, it is an investigation of the history and development of the industry that exists today, a look into the future at the potential industry of tomorrow, and a study of the financial, economic, and strategic implications.

Introduction

The China of today is a rapidly growing economy of over 1.3 billion people. It is a nation with a culture that has developed during the last six thousand years, and is considered one of the longest standing societies on earth. China has a history of being powerful; demographically, militaristically, and economically. In fact, “China has been the world’s largest economy for 18 of the last 20 centuries.”1

The United States is in a different stage of economic growth. As the current largest economy in the world, the Unites States is economically established and does not have the same potential for growth as China. The governments of the United States and China historically have had different views on economic policy. As a result, few similarities exist between the two economies.

The airline industries in the two countries tell a different story. For both, one common theme is shared: “Commercial aviation remains encumbered by the well meaning but outmoded and arcane rules, principles and institutions.”2 The United States’ Civil Aviation Board and Federal Aviation Administration as well as the Civil Aviation Administration of China are organizations under the umbrellas of their respective governments that have played many different roles in supporting, regulating, liberalizing, expanding, and consolidating each’s airline industry. Each organization’s history and current policy play major roles in the forming of industry characteristics. Today, many of these characteristics are in need of change, as the industry in both countries is failing to meet the needs of travellers, governments, trade, and financial stakeholders. The change that is required in China has to do with the characteristics of size and scale of the industry, as well as with its efficiency.

History and Outcomes of the United States Airline Industry

The airline industry as we know it today was primarily established in the United States in the 1920s. The worldwide economic depression of the late 1920s halted its early growth, but as the economy recovered during the 1930s, so too did the airline industry. From 1938 until the passage of the Deregulation Act of 1978, the airline industry in the United States exhibited astounding growth. Under the Civil Aeronautics Board (CAB), the industry was shaped into a financially protected being that was able to grow without being subject to the perils of market forces and economic conditions that could have prolonged its expansion. The CAB was careful to not let the expansion of the industry occur too fast.3

In regulating fares, the CAB’s principle concern was airline profitability. Market and economic factors, such as economies of scale, were not considered when setting ticket prices. Few discounts were permitted to passengers; generally they were only given to students and families.4

In 1978, it became clear that the US airline industry had grown to a level where efficiency, innovation, and low prices could not be simultaneously attained without restructuring it in its entirety. The Deregulation Act of 1978 was the launching pad for this process as it effectively ended regulation of the industry by the CAB. The newly formed Federal Aviation Administration (FAA) was appointed to certify flight equipment as airworthy, to control flights in and out of airports, to license flight crews and mechanics, and to approve and monitor maintenance procedures5.

Shortly after the Deregulation Act of 1978 was passed, airlines began to develop more extensive route structures. Without being bound to any specific classification under deregulation, airlines extended their services into many different markets. Airlines that had previously been categorized as intrastate jet lines, such as Southwest Airlines, instantly had access to the entire nation. Some of these airlines were able to offer considerably lower fares on established high density routes.6

Naturally, problems began to arise. The new entrants increased levels of competition and introduced lower fares, forcing the legacy carriers to lower prices as well. For the legacy carriers, however, the new low fares did not generate enough revenue to cover operating costs. Passengers, seeking a more certain and understood method of transportation, preferred the legacy carriers and for an equivalent price, would give business to the legacy carriers instead of the new entrants. Accordingly, profits fell considerably for both legacy carriers and new entrants, and many Chapter 11 bankruptcy filings took place during the 1980s and 1990s, including TWA, Pan American, and America West7.

The 1990s ended with a surge in air travel demand due to the technology boom that defined the economy of the period. The recession that follwed at the beginning of the millenium, coupled with the September 11 terrorist attacks, caused a severe downturn in air travel demand. Another round of bankruptcy filings took place among the legacy carriers, including Chapter 11 filings by US Airways and United Airlines in 20028.

As the big players of the airline world began to lose control, many new airlines attempted to enter the market. Generally built to cater to leisure travellers, these new airlines were given the name “low-cost carriers (LCC).”9 JetBlue, one LCC that was establised in the early 2000s, made plans that included building a fleet with one type of aircraft to reduce staff training and maintenance costs as well as hiring a team of non-union employees. These new ideas focused on the happiness and comfort of customers, and included seat-back entertainment systems that provided live television programming through a joint marketing venture with DirecTV.10 The competition provided by the LCCs drove down the average fare paid by business travellers to a level 49% lower than the average business class fare at the time.11

For the foreseeable future, the United States airline industry will need to continue to change rapidly. Inefficiencies still exist and are due to a various number of factors including overbooking passengers on certain routes and not booking enough on others, outdated infrastructure, outdated technology, and improper compensation for the members of the workforce. It is impossible to be certain of the direction in which jet fuel and other economically dependent costs will move and whether or not the world economy in general will rebound from its current state of turmoil; however, it is possible for airlines to increase operating efficiencies to the point where unforeseen economic situations can be financially survived.

History and Outcomes of the Chinese Airline Industry

During the 1940s, the infrastructure of the Chinese airline industry was effectively ruined by the war between the communists and the nationalists. Prior to the war, there were two airlines operating in China, one operated by the nationalist party and another by a Sino-American company. There had also been numerous airfields and navigation equipment, most of which was destroyed.12

In 1953, when the first Five Year Plan (FYP) began, the Soviet planning structure took precedence and the industry was centralized. The two airlines merged into a state-owned monopoly and the Civil Aviation Bureau transformed into the Civil Aviation Administration of China (CAAC), which took on all the administrative responsibilities of its predecessor along with the responsibilities associated with managing the airline.

The second FYP, which began in 1958, once again changed the structure of China from a centralized, Soviet-style society, to a society where administration was the duty of provincial governments. Mao Zedong, Chairman of the Communist Party of China, “saw administrative decentralization as a way to maintain participation of the mass in the proletarian revolution and a means to solidify his power with support from communist party bases in the provinces”.13

Under the leadership of Mao, leadership purges, violent public demonstrations, and political attacks at intellectuals and bureaucrats were organized. The country remained in a state of political and public chaos for the next few years, and with this chaos, civil aviation suffered, with air travel significantly declining. The industry did not recover for an entire decade.14 Mao passed away in 1976 and an attempt was made to recentralize the government, but after many years under Mao’s leadership, the government was not fully prepared to make this significant change in structure so quickly.

Under the leadership of Deng Xiaoping, the market mechanism became a consideration for the coordination of the economy. In 1978, only two years after Mao’s death, a plan was introduced that allowed market forces to shape the agriculture industry and foreign investment to take place in newly established special economic regions, areas that the government set aside as test-beds for certain capitalistic theories of economists15. While civil aviation was still years away from being liberalized economically, this was a significant change in Chinese policy that would ultimately open doors for airlines.

By 1991, six airlines had been spun-off of the old CAAC. China’s “big three,” Air China (based in Beijing), China Eastern (based in Shanghai), and China Southern (based in Guangzhou), handled half of the passenger traffic within China. By 1994, there were forty carriers operating in China, although several airlines operated fleets of fewer than five planes.16

The aviation infrastructure established by the CAAC was not meant to support this many airlines and safety was losing priority. In this sense, the CAAC decided to put an end to the new issuance of airline licenses. Further, for the long run, the CAAC declared they would like to have fewer than twenty airlines operating at a time.17

The second half of the 1990s for the Chinese airline industry was marked by a series of irrationalities. Airlines experienced low profitability, rising debts, excessive carrying capacity generated by duplicate construction and poor management, a lack of economies of scale, and widespread aggressive competition. Competition prompted airlines to offer huge discounts on ticket prices to attract large shares of passengers. In addition, during this time period, the rail and super-highway networks in China were greatly improved, increasing the minimum distance for which airlines had a comparative advantage versus other methods of transportation.18 Growth had taken place very quickly and the industry was failing. Beijing decided it was in need of an overhaul.

It became apparent that a more substantial plan of action was needed to revitalize the ailing industry. Operating efficiency was lacking to such a high degree that sizeable action needed to be taken. Finally, in July of 2000, the CAAC released a major restructuring plan for the industry. The plan outlined a reorganization of the ten airlines managed under the CAAC into three airline conglomerates: Air China, China Eastern, and China Southern. Each of these new airline groups would be given sufficient operational autonomy by the CAAC.19

The Chinese Government’s original attempt to deregulate the industry had very negative results on airline profitability. When this consolidation and re-regulation process began, it was unforeseen how permanent the resulting industry structure would be and when deregulation could again begin to take place. For China, re-regulation has been extremely rare; most industries have been pushed consistently towards capitalistic environments.20 According to the Centre for Asia Pacific Aviation, the “central controls will likely be maintained for the foreseeable future.”21

The history of China’s airline industry has been very unique in that it has teeter-tottered, so to speak, from being highly regulated, then deregulated, and switching back again. In China today, much of the industry’s potential for growth exists because the country’s economy is developing rapidly and GDP growth will raise the average standard of living to the point where a significantly larger percentage of the population will be able to afford air travel. In addition, the growing businesses of China will require more and more domestic air travel as trade expands and customer bases increase in size. Finally, as the markets in China continue to open their doors to the international community, international air travel will be required to grow to meet the needs of international business transactions. All of the growth will naturally yield increased amounts of revenue.

Forecasted Growth of Air Travel in China

The airline industry in China has experienced quite a bit of growth from its inception to date. Like the industry in the US, China’s airline industry has undergone major structural changes and modifications in the past, in which government regulations have been removed or relaxed, and growth has taken place. The future appears to be based on a significant continuation of this growth.

In 2026, according to the Boeing market outlook, there will be approximately 6.8 billion airline passengers worldwide, and the largest share, nearly 40%, of these passengers will be travelling from, to, or within the Asia-Pacific region.22 This number, 6.8 billion, is larger than the 2006 world population. In addition, the worldwide fleet of airliners will grow with the addition of 28,600 planes during the period from 2006 to 2026 to accommodate the passenger growth in many regions of the world. It is projected that at that time, the worldwide fleet will be over 36,000 planes, with around 80% having been delivered within this twenty year period. Over 8,000 of these new deliveries will be to airlines in the Asia-Pacific region. This number of new deliveries is only surpassed by the North America region, with over 9,000 projected deliveries.23

As a result of adding a large number of new airplanes to the fleet, the average age of the Chinese fleet has decreased to a level nearly two years younger than the average age in the region.24 All of this rapid growth is due to the government moving towards a further reduction in regulation of the industry and its high levels of investment in aviation infrastructure.25

The improvements to the aviation infrastructure in China will enable the industry to maintain much growth during the next few decades. Currently, the CAAC categorizes too few airports, limited services, saturation at the three main hubs (Beijing, Shanghai, and Guangzhou), and difficulties in co-ordinating civil and military flight paths as the biggest problems facing the industry.26 To begin to correct these problems, three major areas will see the majority of the infrastructure improvements: technological infrastructure, physical infrastructure, and air traffic control infrastructure.

Notes on Next Generation Aircraft

The aircraft delivered during this 20 year period will exhibit many advantages over today’s fleet, advantages that will be seen by passengers, airlines, and the environment. As markets around the world become increasingly deregulated with added competition, and world economic situations change, possibly leading to higher costs and less revenue, it is important for airlines to operate at higher levels of efficiency.

The new generation aircrafts have all been designed around the concept of more efficient operations. Boeing’s new 787 aircraft will offer airlines a 20% reduction in fuel use per passenger. This will reduce greenhouse gas emissions, which will help to preserve the environment. The reduction in fuel use is, in part, due to the use of more efficient turbofan engines, with less of a noise footprint. As a result, the aircraft will be more pleasant and passenger-friendly for travellers. The next generation of aircraft will also have a longer range and a larger payload capacity, which can be translated into an increase in revenue.27

With the large rise in demand for aircraft in the Asia-Pacific region during the next two decades, new deliveries will need to be met with support. The number of personnel required to maintain a rapidly growing fleet will also need to grow with the same magnitude. In addition, there will be an increase in the training standards of personnel and an expansion of local maintenance and overhaul facilities.28

Infrastructure, in general, will have to change rapidly to keep up with growth in worldwide RPK due to the addition of the new types of aircraft. With an increase in the number of flights operated in a given period of time, airport and air traffic control services will need to expand their capacities to meet the growing demand.29 Physically, facilities must change as well. Beginning with Airbus’s first delivery of the new A380-800 to Singapore Airlines in 2007, airports around the world have begun to initiate overhauls of runways, taxiways, and terminals to accommodate this relatively large new type of aircraft.30

New aircraft are essential for the growth of the industry worldwide and especially within China. Because efficiency is the requirement needed for growth, introductions of new and efficient aircraft, today, are highly sought after in all markets, including China.

Notes on the Economy Today and its Implications on the Airline Industry

Today, both the US economy (which is growing by less than 1% as of 2008) and travel market are very weak, but the outlook for China, the Middle East, and Latin America is positive, where the GDP growth forecast for 2008 is nearly 10%. IATA believes that airlines with diversified operations across these regions will be subject to a stronger market than those airlines focused on the United States.31

Between 2001 and 2006, the expense of fuel increased from 13% to more than 26% of an airline’s total operating costs. Since 2006, the price of jet fuel has increased from around US$1.80 to well over US$3.10 per gallon, further increasing its share of airline operating costs to an estimate of 29% for 2007 and a forecast of 32% for 2008.

An additional obstacle exists for the Chinese airlines, however, as the Chinese government requires Chinese Airlines to purchase all fuel used for domestic flights directly from a government agency. Therefore, Chinese airlines can only hedge the price of fuel used on international flights.32 [

As we have discussed, efficiency will lead to a healthy airline industry. With the current worldwide economies, it is as important as ever for airlines to maintain their maximum operational efficiencies and therefore, be able to whether the storm. paJ

About the Author: Matthew Strassberg, originally from Scarsdale, N.Y., is a senior at McGill University located in Montreal, Quebec in Canada. At McGill, Matt is focusing on management, math, and finance.

(Notes)

  1. Patten, C. (2005, September 26, 2005). Why Europe is Getting China so Wrong. Financial Times,
  2. InterVistas. (2006). The Economic Impact of Air Service Liberalization. Washington DC: InterVistas - Global Aviation Associateso. Document Number)
  3. Pitt, I. L., & Norsworthy, J. R. (1999). Economics of the US Airline Industry: Productivity, Technology, and Deregulation. Boston: Kluwer Academic Publishers.
  4. Pitt, Norsworthy, Economics of the US Airline Industry: Productivity, Technology, and Deregulation.
  5. Pitt, Norsworthy, Economics of the US Airline Industry: Productivity, Technology, and Deregulation.
  6. Pitt, Norsworthy, Economics of the US Airline Industry: Productivity, Technology, and Deregulation.
  7. Pitt, Norsworthy, Economics of the US Airline Industry: Productivity, Technology, and Deregulation.
  8. U.S. Airline Bankruptcies & Service Cessations. (2008, April 11, 2008). from http://www.airlines.org/economics/specialtopics/USAirlineBankruptcies.ht...
  9. Gerardi, K., & Shapiro, A. H. (2007). Does Competition Reduce Price Discrimination? New Evidence from the Airline Industry. Boston: Federal Reserve Bank of Bostono. Document Number)
  10. Wynbrandt, J. (2004). Flying High: How JetBlue Founder and CEO David Neeleman Beats the Competition... Even in the World’s Most Turbulent Industry: Wiley.
  11. Gerardi, Shapiro, (2007). Does Competition Reduce Price Discrimination? New Evidence from the Airline Industry.
  12. Le, T. T. (1997). Reforming China’s Airline Industry: From State-Owned Monopoly to Market Dynamism. Transportation Journal, 37(2), 45-62.
  13. Le, Reforming China’s Airline Industry: From State-Owned Monopoly to Market Dynamism., 37(2), 45-62.
  14. Le, Reforming China’s Airline Industry: From State-Owned Monopoly to Market Dynamism., 37(2), 45-62.
  15. Le, Reforming China’s Airline Industry: From State-Owned Monopoly to Market Dynamism., 37(2), 45-62.
  16. Chung, J. H. (2003). The Political Economy of Industrial Restructuring in China: The Case of Civil Aviation. The China Journal, 61-82.
  17. Le, Reforming China’s Airline Industry: From State-Owned Monopoly to Market Dynamism., 37(2), 45-62.
  18. Chung, The Political Economy of Industrial Restructuring in China: The Case of Civil Aviation. 61-82.
  19. Chung, The Political Economy of Industrial Restructuring in China: The Case of Civil Aviation. 61-82.
  20. Perett, B. (2007). Toward Deregulation; China backs up aviation reform with action. Aviation Week & Space Technology, 167(7), 49.
  21. Davies, W. (2007, March 19, 2007). China Air Sector Could Grow by 10 PCT PTS Above Current Level Without Curbs-CAPA. Xinhua Financial Network News,
  22. Warner, M. (2007). Current Market Outlook. Seattle: Boeing Commercial Airplaneso. Document Number)
  23. Warner, Current Market Outlook. Seattle: Boeing Commercial Airplaneso. Document Number)
  24. Warner, M. (2007). Current Market Outlook. Seattle: Boeing Commercial Airplaneso. Document Number)
  25. Warner, M. (2007). Current Market Outlook. Seattle: Boeing Commercial Airplaneso. Document Number)
  26. Anderlini, J. (2008, January 30, 2008). Beijing plans to build 97 regional airports. Financial Times,
  27. Warner, M. (2007). Current Market Outlook. Seattle: Boeing Commercial Airplaneso. Document Number)
  28. Warner, M. (2007). Current Market Outlook. Seattle: Boeing Commercial Airplaneso. Document Number)
  29. Warner, M. (2007). Current Market Outlook. Seattle: Boeing Commercial Airplaneso. Document Number)
  30. Forsyth, P. (2007). The impacts of emerging aviation trends on airport infrastructure. Journal of Air Transport Management, 13(1), 45-52.
  31. Pearce, B. (2008). Financial Forecast. Montreal: International Air Transport Association (IATA). (I. A. T. Association o. Document Number)
  32. Stanley, B. (2005, March 18, 2005). China’s Airlines Take Test Flight; Beijing Sees Carriers’ Deregulation as Bellwether of Life in WTO. The Wall Street Journal, p. 11

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