Flying high: China's aviation industry

The General Administration of Civil Aviation of China ("CAAC") has forecast strong growth for the airline industry, predicting average annual increases in Chinese airline traffic of around 10%, which is based on an estimated 7% economic growth per year. CAAC also anticipates that by 2020, annual revenue tonne kilometers (RTKs) for the country's airlines is expected to reach 84 billion, compared with 16.2 billion in 2002, ranking China's air transport market second in the world.

The country's freight traffic is also expected to grow faster than passenger traffic in the years ahead as the volume of the country's imports and exports increase. Growth will come primarily from the export of consumer and high-tech goods, and the import of capital equipment and high-value manufacturing components, which has increased as a result of foreign direct investment. This growth is likely to be supported by the establishment of new logistics and freight-handling ventures and facilities involving the main Chinese airline companies or their subsidiaries.

The impressive official statistics reflect the economic and structural changes that are taking place within China's transportation industry. This article examines the recent developments affecting the major aviation companies and their related businesses.

Airline Mergers

China's airline industry has been restructured at various times over the years to meet the competing objectives of increased competition and industry consolidation. In the 1980s China divided the former CAAC airline into six regional arms, creating Air China, China Eastern Airlines Corporation Limited (formerly China Eastern Airlines), China Northern Airlines, China Eastern XiBei Airlines (formerly China Northwest Airlines), China Southern Airlines Company Limited (formerly China Southern Airlines) and China Southwest Airlines (now merged with Air China). The industry was further deregulated as provincial and municipal governments were allowed to establish their own carriers.

Later, CAAC continued with industry consolidation after a spate of air accidents. In 2002, the State Council formally endorsed the latest program of airline mergers and airport reform. The new reforms include introducing new route and fleet structures, appointing new management teams, and addressing the issue of the valuation of airline assets.

CAAC announced that the 10 carriers under its direct administration would be merged into three large groups, Air China, China Eastern, and China Southern (the "big three"), in a move aimed at eliminating "disorderly" competition. By rationalizing the industry into three key players, the government aims to minimize costs, reduce overcapacity, introduce economies of scale, and manage the ticket price wars that have plagued the industry in the past.

New Alliances

Airlines immediately began scrambling to find alliance partners, and under the consolidation blueprint that followed, Air China agreed to merge with China Southwest and China National Aviation (owner of CNAC-Zhejiang Airlines); China Eastern's parent agreed to acquire China Eastern XiBei Airlines and China Eastern Yunnan Airlines (formerly Yunnan Airlines); and China Southern's parent agreed to take over China Northern and China Xinjiang Airlines. On 28 August 2003, the merger of Air China, China Southwest Airlines and CNAC-Zhejiang Airlines was successfully completed.

Integration efforts have been moving ahead since late 2002 and it is anticipated that the big three airlines will control around 80% of the China market. Second- and third-tier regional airlines such as Hainan Airlines and Shanxi Airlines are following suit and have also been seeking equity partners among the big three.

The big three are also exploring the benefits of alliances with foreign carriers aimed largely at increasing the yields from business traffic to the Chinese partners through a code-share system. The top three carriers are creating code-share alliances with foreign airlines such as American Airlines, Air France, Lufthansa Airlines and China Airlines.

Hub and Spoke System

CAAC sees the formation of larger airlines as a necessity since liberalization of the sector will be unavoidable and stronger domestic players will be in a better position to face foreign competition. In addition, China is encouraging the big three to use their new subsidiaries to develop a US-style hub and spoke system, in which secondary airports feed larger airports and main trunk routes. Further, this system is intended to improve air services to interior regions, which the Chinese government aims to develop as part of its overall economic policy in respect of Central and Western China. The major obstacle facing the government is, however, the limited demand in areas where the population generally cannot afford to fly and tourism has yet to develop. Since development of these regions is part of the macro-economic policy, funding will come mainly from treasury bonds, civil aviation departments, local governments and foreign capital.

CAAC

Previously, CAAC acted as airline owner, investor, and regulator. Under the present reform, CAAC has given up ownership of the airlines under its direct control and is now focusing on a regulatory role and on its responsibilities for air safety management. CAAC's new role is being largely modeled on the US Federal Aviation Administration.

China's State Council approved the elimination of 23 regional aviation administration bureaux on 15 September 2003 and the transfer of 93 airports from the CAAC's control to local government management by the end of 2003. Yet, CAAC will maintain control over international airports and airports in Tibet.

It has been suggested that the move will allow foreign and domestic companies to acquire a minority stake in the locally controlled airports. By transferring airport management to local governments, the central government will be able to reduce the burden on central funding. In 2002, total losses for the country's airports exceeded RMB 1 billion (US$120.8 million). Estimates indicate that many airports across the country have an utilisation rate of less than 50% with smaller airports running as low as 10%. The airports employ nearly 50,000 people and have assets worth roughly RMB 40 billion ($4.8 billion). Reportedly, only Beijing, Guangdong, Shanghai, Tianjin, and Zhejiang airports currently break even or earn profits.

Fifth Freedom Rights

CAAC negotiates bilateral air services agreements for the Chinese government and has been giving foreign carriers progressively more rights to operate to the country's gateway airports of Beijing, Guangzhou, and Shanghai. China also has been signaling its willingness to open up further and allow more competition between foreign airlines and the country's major carriers. Recently, Singapore Airlines became the first foreign carrier to win fifth freedom rights to operate services beyond China to a third country. Fifth freedom rights refer to permission for international carriers to pick up passenger and cargo on a second country's territory en route to a third country for its flight that originate from the international carriers' habitual base. Singapore Airlines' SIA Cargo has been operating fifth-freedom services to Chicago via Xiamen and Nanjing since May 2003. Authorities have indicated that similar rights could be awarded to other carriers, possibly through Shanghai.

Airport Management

China's current airport plans call for large hub airports with multiple runways and the ability to handle both passenger and freight traffic. Reports suggest that about 30 new airports are expected to open in China by the end of 2005. Many of these airports will be located in remote western cities and scenic areas that may not have the demand to support the airport infrastructure investment.

Much of the air traffic in China flies in and out of a relatively small number of airports. The airports in Beijing, Guangdong Province, and Shanghai accounted for 36.9% of total passenger turnover in 1999 and 26% of total aircraft movement. Among China's small supply of airports, only a minority can handle the largest planes. Only 22 of China's 145 airports can accommodate Boeing 747 and Boeing 777 airplanes. Consequently, in addition to the need for more airports, China must also upgrade its existing airports.

CAAC's priority projects include the opening of Guangzhou Baiyun International Airport, expansion of the Beijing and Shanghai hub airports and improvements in secondary airports, especially in the Central and Western regions. CAAC has also been upgrading its airport flight security, aircraft maintenance, and repair and transport services.

Increasingly, Chinese airports are becoming more aware that to generate revenue, airports have to be run like businesses, and that privatization may be one way of achieving a better return on capital. China has studied the model used by most international airports, in which more than half of total revenues come from sources such as retail and parking facility fees. Airport companies such as Beijing Capital Airport also act as investors in other airport construction projects in the country.

Foreign Ownership Restrictions

Partly to fulfill its WTO obligations, China introduced the Regulations on Foreign Investment in Civil Aviation on June 21, 2002 (the "2002 Foreign Investment Regulations"). The 2002 Foreign Investment Regulations raise the amounts of equity that foreign investors are permitted to hold in various types of aviation projects. The following table sets forth the current foreign investment restrictions indicated in the Foreign Investment Regulations (which have to be read in conjunction with China's Regulations for Guiding the Direction of Foreign Investment and the Catalog for Guiding Foreign Investment in Industry).

Aviation Project Foreign Investment Limits

Note: Foreign investment in air traffic control companies is still prohibited.

Under the previous policy that was issued in 1994, the cap on foreign investment in air transport enterprises was 35%. Foreign investment in airport facilities (including runways, taxiways and parking tarmacs) and airport waiting lounges was limited to 49%. The joint venture parties were free to decide the ratio of foreign investment in airline enterprises for agriculture and forestry purposes.

The 1994 policy also required that the chairman and president of foreign-invested airlines and civil airports be Chinese nationals. The 2002 Foreign Investment Regulations contain no such limitations.

Leasing and Debt Financing

In recent years, the Chinese airlines tend to acquire their aircraft through operating leases rather than finance leases. No doubt the popularity of operating leases was in part due to the competitive lease terms offered to the Chinese airlines as a result of the abundant supply of aircraft arising from the drop in air travel demand in the U.S. and Europe. International Finance Leasing Corporation and GE Capital Aviation Services are the most active operating lessors in China, though other lessors such as Pegasus Aviation, Inc. has recently made a come-back by successfully leasing a used Airbus A320 aircraft to Sichuan Airlines.

Apart from operating leases, the activities of borrowing of domestic RMB loans from the cash-rich domestic banks continue to be popular for those airlines that decide to acquire brand new airplanes. This is mainly due to the desire of airlines to avoid foreign exchange risk and the lower overall financing costs that are made available with these loans. It has been a while since foreign banks last completed an aircraft finance leasing transaction in China, which was the most popular financing structure used in China in the 1990's.

Equity Financing

Although industry observers are waiting for the launch of the Air China initial public offering, in general, equity issues are still rare for Mainland Chinese airlines. However, funding channels have widened with recent IPOs of the main carriers, China Eastern and China Southern as well as Beijing Capital International Airport and China National Aviation Corporation. Moving forward, the Chinese aviation industry is likely to view more positively the benefits of improving the financial structure and raising capital with a listing. The reforms taking place in China's capital markets are also expected to create new opportunities for airlines to obtain financing for equipment purchases and to fund the cost of the industry restructuring.

Foreign Equipment Sales

Foreign companies have been successful in selling equipment and services to Chinese airlines and airports for many years especially as many projects are funded by foreign loans that require the adoption of competitive international bidding. Foreign-invested companies have sold a wide range of equipment including baggage handling equipment, multi-user flight information systems, passenger bridges, etc. Although domestic companies have generally been awarded the contracts for construction of airports, foreign firms have been able to obtain design contracts, especially for the terminal buildings in the major airports at Pudong and Hongqiao in Shanghai and at Guangzhou Baiyun.

AVIC

Similarly, foreign aviation manufacturers have a history of fleet sales and leasing of aircraft to Chinese aviation companies. According to industry estimates, China has a fleet of about 500 planes, with 70% of the fleet being Boeing aircraft and 20% made by Airbus Industrie. One market report suggests that by 2020, China will have more than 2,200 passenger planes, or about 7% of the world's fleet.

China's main aviation conglomerate, Aviation Industries of China ("AVIC") was divided in 1999 into AVIC I and AVIC II: AVIC I focuses on large- and medium-sized aircraft while AVIC II focuses on smaller aircraft, helicopters, and manufacturing non-aerospace related equipment. Both conglomerates have a large number of subsidiaries and research institutes, and are both active in seeking foreign partnerships to keep their plants operating. A similar restructuring is taking place among other aviation service companies. For example, jet fuel supplier China Aviation Oil Supply is also believed to be undergoing restructuring.

Regional Jets

One expected growth area for AVIC is the development of regional jets. China has restricted regional jet imports by maintaining high taxes on imported aircraft weighing under 25 tonnes. This has created an increasing domestic demand for regional jets, which is expected to further increase as Chinese airlines consolidate and improve services inland especially to Central and Western regions.

AVIC I is working on a regional jet (the ARJ21) seating 76 - 105 passengers, while AVIC II has formed a joint venture with Brazilian company Embraer to build regional jets (the ERJ-145) carrying between 37 to 50 passengers. Reports suggest that the ARJ21 should be available for delivery from late-2007. The aircraft is to be built by AVIC I's Commercial Aircraft Company ("ACAC"). China's aircraft manufacturers and their Western partners are anticipating a proliferation of regional jets over the next decade. Both jet projects are expected to expand commercial aircraft manufacturing capabilities and allow government-owned manufacturers to increase their share of the domestic market.

Tariffs and Taxes

Though tariffs on aircraft imports are not prohibitively high (see table), import-stage value added tax ("import-stage VAT") is quite significant. In 2001 China reduced the import-stage VAT to 6% on aircraft imported by airlines under the CAAC's jurisdiction that weigh more than 25 tonnes. However, the import-stage VAT on aircraft weighing less than 25 tonnes was maintained at 17%. Some believe that the reason a high 17% import-stage VAT was maintained for aircraft under 25 tonnes was so that the import of regional jets would remain prohibitively expensive until domestic suppliers have established their position in the market.

Aircraft Import Duties in 2003

When joining the WTO China promised not to raise the tariff on aviation gasoline above 5% and agreed to open its retail and wholesale oil markets by 11 December 2004 and 11 December 2006, respectively. Although the amount of processed oil products, such as aviation gasoline, that may be imported by companies other than designated state trading companies is limited, the amount is increasing pursuant to a WTO-stipulated schedule. With domestic fuel prices estimated to be around 50% higher than international levels, and with fuel costs representing approximately 20% of current airline operating costs, the impact of these measures is likely to be significant.

Outlook

WTO membership has led to progressive liberalization of foreign access to some peripheral aviation areas. Foreign investors and Chinese companies alike are now looking ahead to the opportunities available for the structuring of new business partnerships in a wide range of areas from manufacturing, aircraft and equipment leasing, joint management operations, and strategic equity investments.

The regulatory framework will need to keep pace with these industry developments, and as CAAC expands its supervisory and regulatory role, the turbulence that has dogged the industry in the past may soon subside, and China's aviation industry may be set for a new and possibly clearer course ahead.

HIGH FLYER: SHENZHEN FINANCIAL LEASING CO. LTD.

Shenzhen Financial Leasing Co. Ltd. ("Shenzhen Financial") is the first Chinese leasing company to enter the aircraft industry. There are an estimated ten to fifteen domestic leasing companies incorporated in China and regulated by the China Banking Regulatory Commission. Other players include New Century Finance Lease Co., Ltd., Far Eastern International Finance Lease Co., Ltd, though Shenzhen Financial has been the most active in aircraft-related deals. Shenzhen Financial is unique because although around 80% of the country's operating jets are leased, local leasing firms hold only a small percentage of the business, which is dominated by foreign companies.

In October 2003, Shenzhen Financial announced that it had signed a contract with Xi'an Aircraft Industry (Group) Co Ltd to buy four Xinzhou-60 aircraft, which will be leased to two airlines in Southeast Asia. Reportedly, it will be the first time Chinese-made aircraft have been leased outside the country. Similar deals involving Chinese aircraft makers are expected in the future.

In March this year, Shenzhen Financial leased a Boeing 767 to Hainan Airlines for a period of 10 years. Bank of China provided the loan enabling the company to purchase the aircraft. The financing was considered unusual because previous deals in which a domestic Chinese lessor acted as a financing conduit have typically involved used aircraft. The structure of the deal is similar to the finance lease structure generally used in cross-border Chinese aircraft financings.

One of the factors behind the involvement of a domestic leasing company in place of a special purpose vehicle ("SPV") is that currently, Chinese law does not provide for the establishment of domestic SPVs. In addition, because many of the smaller airlines are debt-laden, Chinese banks generally are reluctant to lend to the airlines directly. Providing finance via a well-established leasing company provides a mechanism to partly insulate the bank from the credit problems of the smaller airlines.

Andrew Lockhart and Harvey Lau are Partners at Baker & McKenzie