Airline Expansion in South China

UNCLAS SECTION 01 OF 05 GUANGZHOU 000681

SIPDIS

SENSITIVE
SIPDIS

STATE FOR EAP/CM AND EB/TRA
USDOC FOR 4420/ITA/MAC/MCQUEEN
TRANSPORTATION FOR ASSISTANT SECRETARY STEINBERG/GLATZ/RAO
USPACOM FOR FPA

E.O. 12958: N/A
TAGS: EAIR ECON CH HK
SUBJECT: Airline Expansion in South China

REF: A) 07 Guangzhou 670
B) 07 Guangzhou 206
C) 07 Guangzhou 109
D) 06 Guangzhou 32347
E) 06 Guangzhou 32163
F) 06 Guangzhou 18105
G) 06 Guangzhou 16330
H) 06 Guangzhou 13550
I) 06 Guangzhou 11471
J) 06 Guangzhou 8841

(U) This document is sensitive but unclassified. Please
protect accordingly.


1. (SBU) SUMMARY: Rich and populous South China has become
an air traffic hotspot. To win market share, airlines in
the region are sharpening their competitive edge by opening
new routes, buying more aircraft, and expanding cooperation
with other airlines. As the Chinese Government deregulates
domestic civil aviation, an increasing number of foreign
carriers and budget airlines have entered the regional
market and now directly compete with major domestic
airlines. A shake-out in this market is inevitable, given
the number of companies that have been lured into it by the
prospect for sharing in what seems to be an ever expanding
demand for airline services. END SUMMARY.

Air Traffic to Grow in the PRD Region
--------------


2. (SBU) The Pearl River Delta (PRD) region boasts one of
China's fastest growing manufacturing centers. Spurred by
strong economic performance, the demand for air transport
in South China is growing rapidly. China's General
Administration of Civil Aviation (CAAC) has predicted that
air traffic in the PRD will grow by 15 to 20 percent each
year through 2010. Airlines are fiercely competing to
capture a larger share of the soaring air traffic market.
(See Ref A which goes into challenges faced by airports in
the PRD.)

China Southern Getting Stronger
--------------


3. (SBU) China Southern Airlines carried 49.2 million
passengers in 2006, up from 44.1 million in 2005. The
airline's main hubs are in Guangzhou and Beijing.
Secondary bases exist in Urumqi (from which the airline
just launched its new service to Jeddah, Saudi Arabia) and
Shenyang. On March 28, China Southern inaugurated its
Guangzhou-Dubai flight on the heels of the Guangzhou-
Kathmandu route opened on February 5. China Southern also
announced the scheduled opening of eight new international
routes from Guangzhou to Yangon, Phuket, Siem Reap,
Vientiane, New Delhi, Sendai, Sapporo, and Luanda later in
the year. As these new routes are launched, the number of
international outbound routes from Guangzhou will increase
from 18 to 26. Weekly international flights will rise from
136 to 182, an increase of more than 30 percent. China
Southern is expected to become a member of the SkyTeam
airline alliance (Delta, Northwest Cargo) in the second
half of 2007. To help support this expansion, the
airline's president said China Southern planned to purchase
68 new aircraft by the end of 2007.


4. (SBU) China Southern has a 60 percent stake in Xiamen
Airlines. Xiamen Airlines carried 7.76 million passengers
and 110,000 tons of cargo in 2006, up 12.1 and 9.0 percent
respectively, and has turned a profit for the 20th
consecutive year. Xiamen Airlines has an all-Boeing fleet
of 43 aircraft that currently fly 140 overseas and domestic
routes. Fueled by regional economic development and
increasing business ties between Xiamen and Taiwan (though,
of course, without any direct flight connections),Xiamen
Airlines plans to add 60 new Boeing 737-800 aircraft by
2013, as well as a few leased jets. As one of Boeing's
most loyal customers, Xiamen Airlines is negotiating with
Boeing for a purchase of 25 jets worth USD 1.8 billion.
More routes will be opened to Southeast and Northeast Asia,
and the airline's capacity will likely double in five years.

GUANGZHOU 00000681 002 OF 005




5. (SBU) Approved by CAAC, China Southern is setting up a
joint-venture airline, Chongqing Airlines, with the
Chongqing Development and Investment Company. The new
airline will involve a total investment of RMB 1.2 billion
(USD 157 million). China Southern will invest RMB 720
million (USD 94 million) for a 60 percent stake and will
also supply aircraft and technical support. Su Liang,
Secretary of the Board of Directors of China Southern, told

SIPDIS
the consulate that Chongqing Airlines will be officially
established on June 18, but there is no date (perhaps July)
for when it will be ready to offer a full range of flights.
(Comment: The June 18 establishment is likely a symbolic
date tied to the 10th anniversary of Chongqing's
designation as a directly administered city, like Beijing
and Shanghai. End Comment.) The new airline initially
will have three Airbus 320 aircraft and will operate
domestic routes from Chongqing to Beijing, Shanghai,
Guangzhou, and Lhasa. Chongqing Airlines will add other
domestic destinations as its inventory of aircraft
increases.

Shenzhen Airlines Triples Profits
--------------


6. (SBU) Shenzhen Airlines posted a record profit of RMB
360 million (USD 46.5 million) in 2006, more than triple
the previous year's result. Shenzhen Airlines President Li
Kun credited the success to the carrier's May 2005
transition from a state-owned enterprise to a privately-run
company. During its reorganization, the airline earned RMB
2.72 billion (USD 353 million) from the sale of a 65
percent stake, originally held by Guangdong Development
Bank, to Bright Ocean Corporation and Huirun Investment
International. Shenzhen Airlines has been China's leading
private carrier since reorganization and the country's
fifth-largest airline. Passenger service grew more than 24
percent year-on-year to 7.1 million, and the load factor
rose nearly 78 percent. This year, Shenzhen Airlines
expects to maintain revenue growth of at least 40 percent
and serve 10 million passengers. It continues to pursue
its "3-6-9" strategy to expand its fleet to 70 in three
years, 100 in six years and 160 in nine years. The airline
took delivery of 12 aircraft last year and now operates 45
A320s and B737s. Shenzhen Airlines will likely add more
flights from Shenzhen to other airline hubs like Guangzhou,
Zhengzhou, and Shenyang.


7. (SBU) Shenzhen Airlines has partnered with Lufthansa
Cargo AG and Deg-Deutsche (a large European development
finance institution) to operate Jade Cargo International.
Last December, Shenzhen Airlines signed an agreement with
the U.S. Mesa Air Group to create a regional airline
specializing in feeder airline services. Shenzhen Airlines
is discussing another commercial aviation partnership with
a Hong Kong company.

Ambitious HNA Group Ready to Win More Market Share
-------------- --------------


8. (SBU) A source at HNA Group told ATWOnline that the
company's next step is to integrate the regional operations
of its subsidiary carriers to "grab two-thirds of China's
regional market share by 2012." The paperwork/permits for
HNA to form the Grand China Air Group (GCAG),which would
integrate Hainan Airlines and six other subsidiaries, are
near completion. Having obtained USD 25 million from
investor George Soros, USD 60 million from Pan American
World Airways, and RMB 1.5 billion (USD 194 million) from
the Hainan Provincial Government, HNA Group Chairman Chen
Feng said the group had successfully completed financing
for GCAG and is now waiting for its public air transport
enterprise license.


9. (SBU) On March 30, HNA Group launched a new regional
airline, Grand China Express Air Co. Ltd., in Tianjian.
The new airline will begin operation this September and
will initially operate 78 routes linking 54 cities. By
2012, it plans to buy 100 commercial jets from Brazil's
Embraer and fly on more than 450 domestic regional routes

GUANGZHOU 00000681 003 OF 005


linking 90 cities.


10. (SBU) Hainan Airlines carried 14.39 million passengers
and 198,700 tons of cargo in 2006, up 12.41 and 22.55
percent respectively. On April 12, the company announced
that it recorded a net profit of RMB 181.6 million (USD
24.49 million) in 2006, a stark change from a loss of RMB
215.82 million (USD 21.92 million) in 2005. The airline
plans to buy two Boeing 737s and one A319 aircraft worth a
total of RMB 1.16 billion (USD 150.6 million),and plans to
lease two A330s and two A319s this year. Hainan Airlines
started operating an Osaka-Beijing route on March 25 by
expanding a code share agreement with JAL, and a Beijing-St.
Petersburg route on May 4. Reopening a direct flight from
Beijing to Geneva is under consideration.


11. (SBU) With JAL as its sponsor, Hainan Airlines is
applying for the membership in the OneWorld Alliance (with
American Airlines) to compensate for its limited overseas
connections. President Chen Feng announced that a
taskforce had been established to help prepare the carrier
to join the alliance. The application is expected to be
approved in 2007. However, industry analysts put Hainan
Airlines in an inferior negotiating position, as alliances
are targeting carriers in Beijing, Shanghai, and Guangzhou,
while Hainan Airlines is based in the southern provincial
capital of Haikou. OneWorld Managing Partner John
McCulloch has told the media that his group was also
negotiating with China Eastern Airlines based in Shanghai.


12. (SBU) On March 8, a subsidiary of HNA Group, Yangtze
River Express, started its inaugural air cargo flight from
Massachusetts to Shanghai. It also launched a Shanghai-
Anchorage-New York-Boston cargo service. HNA Group is
accelerating the development of its overseas route network
as it tries to play a stronger role in the global market.

Foreign Airlines Eye the China Market:
Cathay Pacific Links Up with Air China
--------------


13. (SBU) Cathay Pacific, Swire Pacific, Air China, CNAC,
and CITIC Pacific Limited reached an agreement to change
the shareholder structure of Cathay Pacific, Dragonair, and
Air China in 2006. Under the agreement, Dragonair will be
wholly owned by Cathay Pacific. Air China acquires a 17.5
percent stake in Cathay Pacific, and Cathay Pacific doubles
its shareholding in Air China to 20 percent. Dragonair
will continue to operate under its own name, but with
Cathay Pacific management. Cathay Pacific and Air China
have developed closer cooperation on many fronts, including
the establishment of an air cargo joint-venture in Shanghai.


14. (SBU) Cathay Pacific's first annual report after the
restructuring showed a 24 percent rise in net profits in

2006. The Center for Asia Pacific Aviation (CAPA)
commented that the radical airline ownership restructuring
will unlock "fantastic synergies" for Cathay Pacific. CAPA
believes that Cathay Pacific and Air China can potentially
form the world's biggest combined carrier with a mix of
private equity (via the Swire linkage) and government
support (via Beijing). Eyeing the huge mainland cargo
business, Cathay Pacific started cargo flights to Beijing
in 2006 and added six more weekly flights to Shanghai in
January 2007. On March 27, the CEO of Cathay Pacific
announced the link with Air China and plans to establish a
Shanghai-based cargo joint venture this year. He also
cited "increasing competition" as the reason for Cathay and
Dragonair's combined cargo volume decline in the first two
months of 2007. The airline plans to add 11 more cargo
planes by the end of 2009 as exports from China surge.
Cathay Pacific expects to boost capacity by 10 percent in
2007, 15 percent in 2008, and 10 percent in 2009, with
growth primarily in cargo services.

Deutsche Lufthansa Invests USD 1 billion in Shenzhen
-------------- --------------


15. (SBU) Early in October 2004, Lufthansa Cargo
established Jade Cargo International with Shenzhen Airlines

GUANGZHOU 00000681 004 OF 005


and Deg-Deutsche. As the first cargo airline in China with
foreign ownership, Jade Cargo International started
operations with a commercial flight from Shenzhen to
Amsterdam on August 5, 2006. It now operates twelve
flights weekly from China to Europe. On March 16, 2007,
the President of Lufthansa Cargo met with Shenzhen Mayor Xu
Zhongheng and disclosed that Lufthansa had invested over
USD 1 billion in Shenzhen. Jade Cargo will receive six new
Boeing cargo planes in 2007 and will rapidly expand its
route network in Asia, Europe, and America.

Budget Airlines Stir Up Aviation Market
--------------


16. (SBU) CAPA predicted that budget airlines will take up
20 percent of the market share in the Asia-Pacific region
by 2010. CAPA statistics show that passenger throughput
for budget airlines increased by 55 percent in 2006, while
airlines providing comprehensive services only registered
0.9 percent growth. As the Chinese Government deregulates
the domestic civil aviation market, budget airlines are
emerging and stirring up the market with their low fare
strategy. Despite the existing industrial monopoly,
outdated civil aviation policies, and airport capacity
shortages, budget airlines should continue making headway
in the market so as to be able to compete directly with
major airlines.

Chinese Spring Airlines Fined for Offering Cheap Tickets
-------------- --------------


17. (SBU) Spring Airlines based in Shanghai, the first
airline to announce a budget travel strategy in China,
earned more than RMB 20 million (USD 2.6 million) in
profits last year. A spokesman attributed this success to
the company's slashing of fares by an average of 61.8
percent since its launch in July 2005. Fare reductions
have contributed to an average occupancy rate of 94.4
percent, the highest of any Chinese airline. Spring
Airlines' budget travel strategy has caused regulatory
problems. The company was fined RMB 150,000 (USD 19,405)
for selling over 400 one-yuan tickets on the Shanghai-Jinan
route last year. The fine was for violating the pricing
rule set by CAAC, which sets the lowest discount rate at 55
percent off the standard rate. This is not the first time
Spring Airlines has been targeted by the authorities for
offering cheap fares. The airline submitted a report to
CAAC and the National Development and Reform Commission in
2005 requesting a more flexible pricing system, but never
received a reply.


18. (SBU) The airline will place an aircraft purchase order
worth RMB 4 billion (USD 517.5 million) for 10 Airbus A320s
in 2007. Due to the capacity shortage at Shanghai Airport,
Spring Airlines is planning to build its second home base
in Hainan Province this year. Spring Airlines' routes from
Shanghai to Guangzhou and Zhuhai are popular, and customers
are expecting more routes to be opened in the Pearl River
Delta region.

Foreign Budget Airlines Expand Business
--------------


19. (SBU) Thai AirAsia, a branch of the budget airline Air
Asia, entered the China market in April 2005 by opening a
Bangkok-Xiamen route. Since then, the route has enjoyed an
average occupancy rate of 85 percent. Due to the rising
number of tourists and business travelers, on March 25,
Thai AirAsia increased the number of its Bangkok-Xiamen low
fare flights from four to seven per week. This year, the
airline plans to open two to four new routes in China.
However, the Vice President of Air Asia blamed China's
airport capacity shortages for raising the airline?s
operating costs and said the official aviation monopoly has
been a barrier for opening new routes in China. As a
result, Thai AirAsia has to operate on less traveled routes.


20. (SBU) Singapore's Tiger Airways launched its inaugural
flight to the Chinese mainland with a Guangzhou flight on
April 25, 2006. Since then, it has opened additional

GUANGZHOU 00000681 005 OF 005


flights from Singapore to Guangzhou, Shenzhen, and Haikou.
On March 25, 2007, an additional two weekly flights to
Shenzhen and Guangzhou were added to its summer flight
schedule to meet the strong demand for low fare air travel
on these popular routes.


21. (SBU) Other budget airlines are also winging their way
into long-haul territory. Oasis Hong Kong Airlines began
to offer flights to London's Gatwick Airport on October 25,

2006. It hopes to expand its Hong Kong service to Oakland
and Chicago this year. Oasis is taking aim at Cathay
Pacific Airways by offering promotional one-way economy
class fares for HK 209 (USD 27),compared with Cathay's
current fare of about HK 530 (USD 68). Oasis' chief
executive and founder Stephen Miller noted that Oasis is
trying to coordinate its schedules and operations with
those of other budget airlines in Britain and the United
States. If it succeeds, Oasis could wind up forging the
first links of a world-wide network of low-cost carriers.
"It would be a sort of strategic alliance," said Miller.
Oasis executives say they have met with counterparts from
Britain's easyJet, but an easyJet spokeswoman declined to
confirm such talks.

COMMENT: CAAC Plays a Key Role
--------------


22. (SBU) As economic growth continues and average incomes
rise, the tremendous growth in air travel demand will
continue to make South China a hot spot for airlines. As
airlines rapidly expand their business in the region, a
price war can be expected in the near future. Problems
with slot allocation and route networks will worsen and
hinder commercial aviation development. CAAC will have to
step up to reform China's civil aviation management system
and create a healthy business environment in the aviation
sector, otherwise growth may stall.


23. (U) This cable was coordinated and cleared with
Consulate General Hong Kong and Embassy Beijing.

Airlines At-A-Glance: 2006
--------------
Potential
Airline Passengers Cargo (tons) Alliance

China Southern 49.2 million 851,580 SkyTeam
Cathay Pacific 18.1 million 1,308,000 OneWorld
Hainan Airlines 14.39 million 198,700 OneWorld
Xiamen Airlines 7.76 million 110,000 SkyTeam
Shenzhen Airlines 7.05 million 107,000
Tiger Airways 1.3 million
Spring Airlines 1.13 million
Thai AirAsia 1.13 million


GOLDBERG