China: flying dragons revived

When I was living in Beijing ten years ago, I remember being amazed by a Chinese developer being able to build a 10-storey mall in busy Wudaokou university area within 7 months. Workers were working 24/7 of course, which is nothing exceptional in China, but the center was opened on-time. So what does it actually have to do with aviation? There is one thing. When a Chinese developer says the construction will be finished in 7 months, it will be finished in 7 months. At all cost. When the PRC government said China would evolve into the biggest aviation market, it became quite obvious that it was exactly what was going to happen.

China (PRC) is going really big!

In 2018, 13% of worldwide departing seats will be originating in China (15% if Hong Kong, Macao and Taiwan are included). Although PRC is still in the second place, after USA, it is quickly chasing the leader. The US, being 3.5 times bigger than China back in 2008, has lost quite a lot of its capacity share (-8pp down to 20%) while its rival has gained +6pp. In other words, China Mainland is now only 0.3 times smaller than USA and is likely to take the leading position in the coming years. While US seats have been relatively flat (+6% vs 2008), China has grown +154% (!) in the same period (+432m seats per annum vs 2008). Obviously it was possible mainly thanks to its insatiable domestic demand fuelled by fast GDP growth (11% CAGR during last decade).

But China has also revealed its big appetite for international market expansion. While world has been growing at +4.8% per annum since 2008, PRC has been almost twice as fast (+8.9%) and has become the 5th biggest international market (7th 10 years ago). It is not surprising at all that China was the one that contributed the most to the total overall growth. Most of this contribution has been driven by Chinese carriers. 55% of incremental seats (2018 vs 2008) have been supplied by Mainland operators, which are frequently state owned and/or subsidised. Another 10% of additional capacity has been provided by non-Mainland Chinese airlines, leaving only 35% for foreign carriers.

Now, if we consider long haul growth only, domination of PRC based operators becomes even more clear. 95% (!) of additional seats between China Mainland and Australia has been driven by Chinese carriers followed by 73% when Europe is concerned and 70% in case of the Americas. Looking at those regions altogether, as much as 56% of additional seats have been provided by 3 state-controlled giants: Air China, China Eastern & China Southern.

10 years ago, there were only 7 Chinese cities that had direct links to Europe. If we exclude Russia from the group, this number goes to down to 5. Out of total 40 direct routes available back in 2008, 45% were flown only by European carriers. 80% of all routes were operated to/from Beijing or Shanghai, leaving limited travel opportunities from Guangzhou, Chengdu, Nanjing, Urumchi and Sanya. All this was resulting from a very regulated aviation market, restrictive bi-lateral agreements and Chinese carriers lacking wide body fleet. One could ask, why haven't China let foreign capacity flood the market then? Well, they came up with quite a different solution...

Do it the Chinese way

Instead of letting others grow and take advantage of a quickly developing, lucrative market, they have decided to steer the growth into Chinese owned carriers' hands. PRC main operators have received hundreds of new long haul aircraft between 2008 and 2018, which together with lower operating costs (vs Europeans, Americans or Australians) and growing traffic originating mostly from China, has given them a strong, competitive advantage. Obviously, there are more conditions that are in their favor, including protectionist government policies or slot constraints at main gateways, that are applied mostly to foreign carriers seeking growth. And in case of routes to/from Europe, there is one more. Given historical friendship between PRC and Russia, Chinese owned carriers are exempt from Siberian overflight charges, which may shift profitability a lot.

Today, there are 92 direct routes between China and Europe. Only 18% of them are operated solely by European carriers, meaning that the market is being reigned by advantaged, Chinese operators. They have been growing not only on trunk routes but have also opened a number of niche services. These include for example Air China's Beijing-Minsk-Budapest-Beijing triangle route which seems to have much more political than rational sense or Sichuan Airlines' Chengdu-Prague route which looks like an effect of local government's "marketing" support funds.

Also, as Beijing and Shanghai airports have both become rather congested, the PRC government has been supporting growth of international air links from secondary cities (and to be completely clear, that means 10+ million metropolises). This policy has been very successful and now (as per the map above) 51% of routes linking China with Europe bypass these 2 hubs. In 2018, 16 secondary Chinese gateways will have direct connections with the Old Continent with 75% of routes operated by Mainland registered carriers.

Would the rise of the Chinese flying dragons be possible if it wasn't for a series of competitive advantages? I don't believe so. Some routes that have a doubtful economic sense today would definitely become unprofitable should the Chinese airlines be subject to Russian royalty fees. And the carriers themselves would act much more carefully if they knew they were on their own. On the other hand, why shouldn't the Chinese government be helping the carriers it owns? The biggest global carriers have already received a lot of state support from their governments before (and some still keep receiving it one way or another), which they tend to forget while advocating for competitive fairness worldwide.

Can the West keep up with China?

It is true that China aviation market is vast and still booming but it is also rather cheap. Although it is not hard to maintain high load-factors on any Chinese route, numerous successful global carriers struggle to make their Mainland network profitable. This is caused both by their unit cost being higher than of their Chinese rivals but also by yields being lower than on US markets for instance. Unit revenues on China routes are subject to constant competitive pressure coming from relentless Mainland carriers which, backed by their government policies, continue adding more capacity to the market. And it will not change any time soon as China keeps investing in additional airport infrastructure. Frankly, I think that Chinese airlines will have a much bigger effect on their European counterparts than Emirates, Qatar and Etihad altogether.

So is it a game over for foreign carriers in China? Will Mainland airlines ever start to stabilise their capacity bringing an ease to yield pressure? At some point in future, international growth potential will start saturating. Also, as Chinese GDP per capita is growing, Mainland carriers will need to invest in customer experience, which costs. Neither will happen soon though so for the time being, cost structure should be the main focus for foreign operators that want to be successful in China. And being successful there means having margins that break even run-rate while growing market share and waiting for China to mature.

Such strategy is less attractive to investors who seek high ROIC short term. On the other hand though, airlines that invest in China now, one day will be sipping their mojitos milking Chinese cow, while others will be making nervous moves to grab any cake leftovers having skipped the before-party. Lufthansa's 7 direct routes (5 from Frankfurt & 2 from Munich) to China make it the biggest European operator in Mainland. And profitability? It is probably the least thing these guys need to worry about, even if these 7 routes underperform. Also Finnair, that operates the biggest number of destinations in China (6) with its network being focused only on Asia, seems to be very certain Mainland is the right answer to its needs today and in the future.

What are your thoughts? Do you think it is wise for foreign long haul carriers to grow their network in China?