More people are taking to the air over China than ever before. In 1995, Chinese airlines ranked 11th in the world in terms of passengers carried. Currently they rank second, behind only US air carriers, a result of consistently high growth. Passenger numbers rose 33 percent in 2004, a recovery from the effects of the 2003 SARS crisis, and 20 percent in 2005. If foreign airlines are taken into account, growth has been steady at around 17 percent for the last two years, and most analysts agree that growth will be between 10-15 percent for the medium term.

The number of Chinese flying now is to be expected, a predictable by-product of the general economic trends on the mainland. With China's increasing involvement in global commercialism, there has been a corresponding growth in the number of business travellers; and not only is China becoming one of the world's most popular tourist destinations, China's middle class is using its newfound affluence to take advantage of greater freedom to travel abroad.

Trouble at home

In a market where there is such a high demand for seats, the Chinese aviation industry is at present in surprisingly rocky territory, with the Civil Aviation Administration of China (CAAC) reporting that Chinese airlines lost RMB2.14 billion during the first quarter of 2006.

Take China Eastern, for example. It seems like it should be a profitable enterprise: in the first quarter of 2006 it carried 11.1 million people, an increase of 9.7 percent on the same period the year before; and it has recently announced that it is going to vastly increase its fleet over the next few years, with the intention to expand from its current 190 planes to 322 by 2010. This is at the same time that it made a net loss in 2005 of RMB467 million - a figure that seems insignificant when compared to China Southern's 2005 net loss, a hefty RMB1.85 billion. The only one of the big three Chinese airlines to make a profit in 2005, was Air China, which managed to increase its profit by 1 percent to RMB2.4 billion.

Chinese airlines have cited the high cost of fuel as the main cause of their troubles. The price of aviation fuel is controlled by the National Development Reform Commission (NDRC), who has been keeping prices high. This puts immense pressure on the profitability of mainland airlines, says Zeno Tse, an aviation analyst at China Everbright Research. "The domestic jet fuel price has been about 25 percent higher than that in Singapore, a common benchmark, in the past two years. Currently, the fuel cost accounts for more than 30 percent of the total operating expenses of the mainland airlines, which means that they are particularly vulnerable to any further hike in jet fuel prices."

The airlines are limited in how they can react to the high price of fuel. Since the domestic market was liberalised last year, a number of new airlines have started up, making the market much more competitive. Therefore, the airlines are unable to raise ticket prices to offset fuel prices, for fear of being undercut by their competitors. Because the problem is potentially here to stay - a recent Chinese-US workshop on aviation fuel predicted that in 2010 China's demand for aviation fuel will double to about 15-17 million tons, from 9.3 million tons used in 2005 - long-term solutions may be more desirable.

But a recent report by Fitch Ratings claims that the high price of fuel isn't completely to blame for the losses. Fitch says that while the revenue Chinese airlines generate per unit is generally in line with other airlines of the Asia Pacific region, their costs are much higher than their competitors'. The unit costs of the big three Chinese airlines are 15-40 percent higher per unit than Cathay Pacific's costs; and even if fuel expenses were excluded their unit cost would still be 15-30 percent higher.

What makes the difference, according to Fitch, is a combination of inefficiency and high structural costs. Chinese airlines are using older, less fuel-efficient planes, often on short routes, which by their very nature are wasteful in terms of fuel. Eliza Liu, Associate Director of Corporates at Fitch Ratings, said high operating costs are behind China Eastern and China Southern's continued losses. As well as rising domestic fuel prices, Liu explained that they pay fixed airport charges, there is no fuel hedge and they face higher marketing and sales expenses relative to foreign carriers. Also, she said that they're still paying integration costs after having recently absorbed a number of smaller airlines.

But what about the impact of foreign competition on domestic airlines' bottom lines? With foreign airlines capitalising on opportunities to open lucrative international routes into China, this could very well be an important contributor to the losses that Chinese airlines are making. On the other hand, it could be just the opposite.

Enter the Dragon Air

In June, Cathay Pacific made major news when it announced it was going to purchase Dragonair for HK$8.2 billion. This deal is significant for two reasons; the first is that Cathay Pacific can now profit from Dragonair's mainland domestic routes, including the lucrative, long-coveted Hong Kong to Shanghai route. Secondly, it marks increased integration between a mainland Chinese airline and a foreign competitor. As part of Cathay Pacific's buyout, Air China agreed to relinquish its stake in Dragon Air in return for 10 percent of Cathay Pacific; while at the same time, Cathay Pacific agreed to increase its stake in Air China from 10 percent to 20 percent.

The benefits of this alliance include reciprocal sales representation, with Air China taking over the responsibility of selling Cathay Pacific tickets in mainland China, and Cathay Pacific being similarly responsible in Hong Kong, Macau and Taiwan. There will also be joint-venture routes between Hong Kong and major cities in mainland China, as well as a number of other profit-sharing agreements.

"It's a very good deal for Cathay Pacific and possibly a good deal for Air China," said Liu. "The strategic alliance between Cathay Pacific and Air China could increase their market share on Hong Kong-to-China routes and put greater pressure on China Eastern and China Southern's load factors, yields and profitability on Hong Kong to China routes."

It is evident then that in this case the entry of a foreign airline into the market is not bad for all. Air China stands to benefit from its alliance with Cathay Pacific, but at the expense of the other mainland airlines who will feel the pinch of increased competition. What Air China has to watch out for is that Dragonair flights don't become so attractive that they themselves end up losing revenue to their new ally.

Buying an existing airline, as Cathay Pacific has done, is one way of entering the Chinese market. Will other foreign carriers follow suit? Tse thinks it's possible: "There have been rumours that some foreign airlines may acquire stakes in China Eastern as a strategic partner. Even if it is true, however, I believe a total buyout is unlikely and that the government will keep a controlling stake in the airlines."

European interaction

European airlines have been quick to take advantage of the demand for international travel to and from China. It's a fast-growing market: in 2005 air traffic from China to Europe increased 20-25 percent, and from Europe to China it rocketed 30 percent. Currently, European airlines have the edge over their Chinese counterparts on flights between Europe, but they're catching up fast.

Frank Legre, General Manager of Air France in China, said 63 percent of carriers in China are European, but that this share is getting smaller as Chinese carriers increase their capacity. "In the middle run I think we'll have a balanced sharing between European and Chinese capacity."

It is in the interests of Chinese airlines to expand as much as possible into international flights, because it is these profitable routes that can offset the high costs of their domestic operations. It should therefore be no surprise to discover that the only major mainland Chinese airline making a profit, Air China, is the airline with the highest proportion of international flights, and the Chinese airline with the biggest loss, China Southern, is the airline that has the highest proportion of domestic flights.

The increased interest of foreign airlines in routes to and from mainland China has inevitably led to direct competition, with Chinese and foreign airlines competing for the same international routes. But this interest is also brokering some cooperation. "What is important is to get traffic from cities where we do not already fly," said Legre, who is also Chairman of the European Chamber of Commerce's Aviation Working Group. "We want to get customers from places we don't fly to directly, to our gateways in Beijing and Shanghai, and then have them sent off to Europe." To this end, international airline alliances are taking Chinese airlines into their fold in order to get customers from all over China, not only from their Chinese hubs. In May, Air China was invited to join the world's largest airline alliance, Star Alliance, and China Southern has been invited to join Sky Team in 2007.

Time will tell whether this kind of arrangement is to benefit the Chinese partners. Being part of an international alliance could give Chinese airlines an advantage in the mainland domestic market; alternatively, it could give foreign airlines the opportunity to exploit the Chinese domestic market, allowing them to get passengers to their international hubs without having to fully pay the mainland's expensive operating costs.

The problems facing European airlines in China are the opposite of those facing their competitors. They face the consequences of expanding too quickly for Chinese infrastructure to catch up. In terms of traffic rights, in the last few years the Chinese Government has been liberal in its approach, said Legre. "But slot coordination and slot shortage is a really big issue. There has been a big increase in traffic, so the skies are a lot busier. I think that the ground premises are not growing at the same pace. The gap should be closed quickly. There will soon be new terminals in Pudong and Beijing. Still, key aspects need to be tackled: immigration and air traffic control can be very slow."

Chinese airlines have no choice but to operate within the constraints of their environment; they will continue to pay high fuel and domestic airport charges for the foreseeable future. Inefficiency is something that they will have to sort out on their own. The quickest way that they can lift themselves off the ground is to expand into international routes, which is something that they are already doing. What they will have to decide is whether they will be better equipped to do this by allying themselves with foreign airlines or going it alone.

Rising fuel costs mean everyone loses

If you've noticed air fares for flights home creeping steadily upwards over the last two years, there is a reason. Oil prices around the world have gone up sharply since the middle of 2004, causing airlines to raise ticket prices across the board.

But fuel costs haven't risen equally for all airlines. While international oil prices fluctuate continuously, airlines in China are at the mercy of regulators like the National Development and Reform Commission and the Civil Aviation Administration of China who reset prices every three to four months.

In May, for instance, the central government raised prices for gasoline, diesel and jet fuel US$62.31 a metric ton to both guarantee supply of refined oil products (such as jet fuel) in China's domestic market and offset the refining margin, the difference in price between crude oil and refined products. The price hikes help appease China's loss-making oil refiners, particularly the refinery businesses of the country's two largest oil companies, Sinopec and PetroChina; industry analysts believe the current round is aimed at moving the negative refining margins of about US$1 a barrel from the first quarter up into positive territory.

Before mid-2004, oil was between 30 and 80 percent more expensive in China than elsewhere. While international prices have experienced a 92 percent rise in the period since then, the increase in China has been closer to 60 percent. The gap between international and Chinese prices has now shrunk to a percentage difference ranging in the single digits. "The difference between oil costs for Chinese airlines and international airlines is not that much anymore," says Karen Chan, an analyst at Credit Suisse in Hong Kong.

Although that may sound like good news for domestic airlines, the reality is that their costs remain high and they will continue to operate at a loss, Chan says. The only difference is that, since international carriers' costs have increased as well, they will suffer along with their counterparts.