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North Asia’s aviation gradually breaks with tradition but a legacy mindset persists

Airline Leader

To appreciate the change in North Asian aviation, consider the number 25. China Eastern Airlines in Sep-2014 unveiled a new brand - its first in 25 years - that is designed to convey modernity and an internationally minded approach to coincide with significant long-haul growth. Taiwan last certified a new airline about 25 years ago, but by the end of 2014 expects to certify two new ones.

Reflecting the change in airline strategy and consumer demands, both Taiwanese airlines are low-cost subsidiaries, one - Tigerair Taiwan - a JV between full service China Airlines and pan-Asia LCC group Tigerair.

Three new LCCs launched in japan in 2012, a fourth did so in Aug-2014 and a fifth expects to do so next year. But as is often the case, it is China that re-defines perception: about 20 airlines have recently launched in China or expect to launch within a year. No other region presently has as many new airlines, with this volume possibly not seen since US deregulation in 1978.

A change of regulatory views in China and Japan is driving the changes, but airlines are also - finally - breaking from traditional thinking. They are becoming more efficient and also embracing the low-cost travel phenomenon that pervades other major regions.

Korean Air has had an LCC offshoot, Jin Air, that the parent had previously underutilised. But now about to take the lead in LCC growth, Jin Air will get some real big boys' toys; its first 777 is due to arrive by the end of 2014. China's HNA Group converted Hong Kong subsidiary HK Express into a LCC in 2013, and with Tigerair Taiwan's Sep-2014 launch, all of North Asia's major markets now have a LCC.

The change in North Asia is often in the low-cost sector, which still remains small. The mighty full service airlines - some of the world's largest - are changing more slowly. They are often characterised less by change than the legacy mindset that still pervades. Despite its new look, China Eastern, like other state-owned airlines, remains overweight. ANA, once Japan's solely domestic carrier, now has more international capacity than Japan Airlines but must confront its unenviable position as having the highest CASK among Asia's major airlines.

LCC penetration in China*: 2009 to Jan-Aug-2014

China's new airlines, often subsidiaries of existing ones, are being added to an already overly-expansive scene; consolidation is inevitable but requires local governments backing the start-ups to give up the prestige of "their" airline for the benefit of scale and synergies. Countries, as the saying goes, must have a local beer and an airline, but this also apparently applies to Chinese cities and provinces as well.

With their much more conservative aviation policies, North Asian markets have long been in the shadow of Southeast Asia's competitive dynamics. But now as growth pauses for breath in Southeast Asia and some legacy airlines there face a serious reckoning, North Asia's stable dynamics are more appealing.

In the past decade, it had been Japan that was home to North Asia's changing regulatory framework. Japan permitted new LCCs while opening up Haneda to greater international services. But now it is China where the regulatory environment is changing. To be certain, China remains a far from liberalised market and the government's involvement is heavy, especially at state-owned carriers. But in late 2013, China upheld LCCs as an efficient growth mechanism, and after years of neither endorsing nor rejecting LCCs, they suddenly became the favourite child.

Concurrently, China rolled out the welcome mat to new airlines, expecting new LCCs to launch. But, although it is early days, almost all of the start-ups are so far following the established full service model. Launching a new airline on the LCC platform, which for China is still relatively rare, has perhaps been judged to be too difficult, or there is insufficient understanding of the model. And for the start-ups with regional government backing, full service may be preferred, if only for the local prestige they deliver.

The exception is Guangzhou's 9 Air, the majority owned subsidiary of Shanghai's Juneyao Airlines, a full service airline. 9 Air is due to launch by the end of 2014 and will be China's first new LCC start-up. Other existing airlines have been converted to the LCC platform, including HNA's West Air. HNA has mooted transforming Beijing Capital Airlines into a LCC as well; China Southern is considering transforming its subsidiary Chongqing Airlines (based in Chongqing, as is West Air).

Air China has remained opposed to having its own LCC, but may follow the trend and convert a smaller subsidiary into a LCC. China Eastern has made the largest move so far by converting Beijing-based China United Airlines into a LCC. But the changes are gradual: China United still offers a premium cabin, and while new management is more reformist in its outlook, they still come from China Eastern.

The new carriers abound, and with high growth aspirations (usually with fleet projections nearing or surpassing 100 aircraft by 2020), but for now the story remains focused on China's four main airline groups: state owned Air China, China Eastern and China Southern plus the private HNA. These groups, including their flagship brands and numerous subsidiaries, account for almost the entire domestic market.

Airlines such as Juneyao and Spring that are not affiliated with another carrier are rare. The domestic market continues to be characterised by over-capacity: the state created growth plans when the economy was stronger but these fleet plans have not been changed since. Airlines are frustrated that they must take excess aircraft while at the same time having their financial performance assessed.

Short-haul international has been difficult to manage, but North Asia overall remains strong. The Korea market is now more important than Japan, although demand for Japan is rebounding. Cross-Strait flights to Taiwan are still high yielding, but growing capacity is forcing yields down and inevitably this trend will continue as capacity further increases.

Southeast Asia has lost some lustre as a destination due to various factors: political instability in Thailand, anti-China protests in Vietnam and the MH370 tragedy and kidnappings of tourists, turning Chinese away from Malaysia. Singapore was often visited as part of a tour to Malaysia and Thailand, but with weak Chinese interest in those two markets, Singapore is being passed over.

After years of growth, there were declines in tourists visiting Malaysia, Singapore and Thailand. North Asia, in contrast, is still recording growth, and often faster growth than before.

Finally there are the long-haul flights, which are prestigious but typically lacking in profitability. Nonetheless they are growing across the board, mainly to North America where the rebounding economy and increased visa processing from the US is supporting growth, although there are short-term capacity issues. Air China is concluding a large North American ramp-up while China Eastern is about to start as it takes delivery of 20 777s, mostly destined for North America. After large and unprofitable expansion, China Southern signalled its intent to bed down growth.

But China Southern is launching new long-haul services, including from secondary Chinese cities to Europe and North America, and justifying them on the grounds it is receiving local subsidies (although the size of these is unclear). Hainan Airlines, which has quietly built a North American network operated by 787s, has mooted acquiring more aircraft to continue the momentum.

International airline partnerships are still in their infancy in China. Beyond basic codeshares, China Eastern has a strategic partnership with Delta, which is open to a joint venture (but only once the prerequisite open skies are in place). China Eastern and China Southern have a limited JV with the Air France-KLM Group, while Air China and the Lufthansa Group have announced plans to form a JV, although this will take some time to materialise.

Both China Eastern and China Southern, members of SkyTeam, are partners with oneworld's Qantas, and China Eastern would like to deepen that arrangement.

Not only is the Chinese market large - soon to be the world's largest - it is highly varied, with for example the leisure-oriented Australian market being very different from North America with its corporate opportunity. North Asia's aviation is experiencing very different fortunes from Southeast Asia, while its core domestic market is undergoing the largest change in recent years. Managing this, with continued growth, is an exceptionally difficult task.

Japan domestic passenger numbers: Jan-2007 to Jul-2014

Japan domestic market share based on passengers flown: FY2013

Like China, Japan's market is primarily a domestic one. But whereas China's economy is growing fast (if not as fast as before), Japan's is slowing. Yet despite this, Japan's domestic air travel market grew 7.8% in the year to 31-Mar-2014. The nearly 90 million domestic passengers in 2013 are close to the 97 million or so passengers seen in the early 2000s.

Further growth may hinge on the impact of Japan's controversial raising of the consumption tax. ANA and JAL initially said they have felt no impact, but that may change as more data becomes available.

More than a third of the additional domestic passengers in 2013 were carried by All Nippon Airways, but this was done through ticket discounting, impacting yields. JAL accounted for about 17% of the additional passengers, while two of the new LCCs, Jetstar Japan and Peach, combined carried more additional passengers than ANA, showing the undoubtedly positive impact LCCs with their lower fares are having on Japan.

But the story is not entirely upbeat. The service-minded public is still slow to embrace LCCs, whose domestic flights operate out of less convenient airports (Narita instead of Haneda in Tokyo, and Kansai instead of Itami in Osaka, although there is a sizeable catchment area that is closer to Kansai than Itami). This is challenging financial performance, although Peach reported a profit in FY2013.

Peach is shifting into the international market while Vanilla Air, the re-born AirAsia Japan, also expects to focus on the international market. Jetstar Japan set out to be the largest domestic LCC, but expects to commence international services shortly.

The new LCCs are gaining size and attention over smaller regional carriers such as StarFlyer, Solaseed and Air Do. This group of "new entrants", which launched in the 1990s, is most notable for Skymark Airlines. Skymark remain's Japan's third largest airline (but much smaller than number two, JAL) and had a strong strategy of building on Haneda slots and lower costs compared to ANA and JAL to carve out a niche. Skymark enhanced this by using A330s in an all-premium economy configuration to grow Haneda capacity where slots were not available, and to offer a superior service to ANA's or JAL's at similar or lower prices.

Unfortunately in 2014, Skymark's existence became endangered, with an ill-advised order for A380s it eventually realised it could not accept for delivery and whose cancellation fees were understandably high. ANA has shown interest in Skymark to provide a solution whereby it takes the A380s and uses them in the domestic market while partnering with Skymark. Yet this basic plan is hampered by the weak relations between ANA and Skymark. The latter expects to conclude its A380 penalty agreement with Airbus in Oct-2014.

Skymark's exit from the A380 and long-haul plans leaves ANA and JAL as Japan's long-haul carriers, although Skymark has mooted A330s to serve Hawaii. Partnerships are the cornerstone of ANA and JAL's long-haul networks, with all of ANA's long-haul network being covered by JVs: United to North America, Lufthansa Group to Europe.

An exception will be if ANA brings to fruition a mooted service to Istanbul in partnership with Turkish Airlines. Japan Airlines' network is likewise covered by American Airlines to North America and British Airways and Finnair to Europe. Only JAL's Sydney route operates outside of a JV.

ANA is now larger than JAL internationally, and expects in the medium term to have more international than domestic capacity. Long-haul growth is key for ANA and JAL, the latter due to resume Osaka Kansai-Los Angeles service while considering re-opening the Sao Paulo extension of Tokyo-New York, in addition to other new routes. Regional short-haul will increasingly see the presence of Japan's LCCs. In particular, Spring Airlines Japan (a JV with China's Spring Airlines) is looking to serve the Japan-China market, while Vanilla Air will open leisure destinations ANA could not suitably make work.

Korea has become Asia's newest hot destination for tourism, building on existing business interest. Demand is particularly strong from Greater China, where fictional TV shows promote Korean culture. New regional flights are being added with growing leisure demand met by local and foreign LCCs. But Korean carriers face a limited air service agreement with China, with a recent expansion being relatively small. Further, China has clamped down on the charter flights Korean carriers employed to get around traffic restrictions.

The restricted China-Korea air service agreement impacts Korea's two full service airlines, Korean Air and Asiana, as China is a huge source market for their long-haul flights, especially to North America. Korean Air, the largest Asian carrier across the Pacific, is having subdued growth as it seeks to restore profitability, with positive signs so far. Asiana is still growing, especially long-haul, as it seeks to re-balance from short-haul to long-haul traffic.

Asiana sees itself too exposed to short-haul markets, which are either vulnerable to LCCs or with marginal benefit. At the same time, Asiana is punching below its weight when it comes to exploiting Seoul Incheon's very good geography - and available slots - as a transit hub. Asiana is growing with the introduction of A380s, and later A350s, but this may still see it fall short of potential.

Asiana is now under the helm of new CEO Kim Soo Cheon, the former CEO of Air Busan. Asiana has a minority stake in Air Busan, based in Korea's second-largest city of Busan. Asiana now wants to capitalise on growth in Seoul with a LCC based there, but faces opposition from Air Busan shareholders. Independent Jeju Air is leading the Seoul LCC market, but Jin Air, affiliated with Korean Air, aims to regain the initiative by deploying Korean's 777s on long-haul flights; routes being considered include Hawaii (Australia and Europe are mooted), as well as slot-constrained Asian destinations such as Hong Kong.

Korea's other independent LCCs, Eastar Jet and t'way, are small but remain in business to the surprise and frustration of competitors. An attempt by AirAsia to enter with a local subsidiary was effectively squashed.

Slots have driven the story in Hong Kong, where local carriers in recent years have prioritised slot usage, with a view later to bringing them to profitability. For Cathay Pacific, this meant using subsidiary Dragonair to grow short-haul traffic, creating an imbalance with long-haul traffic, exacerbated by a temporary reduction in long-haul capacity as 747s were replaced with smaller but far more efficient 777s.

Long-haul traffic is rising again, with North American capacity restored and the network to grow with passenger service to Boston, as well as Manchester and Zurich. Like Asiana, Cathay is re-balancing to emphasise long-haul. However, as the local Hong Kong market becomes near-saturated, Cathay's focus is growing towards connecting traffic, dragging down yields.

Hong Kong International Airport local (non-foreign) airline market share by seat capacity: Week commencing 13-Oct-2014

Hong Kong may get its second publicly listed airline as Hong Kong Airlines prepares an IPO mainly aimed at retail investors who may overlook the airline's opaque structure. The question for Hong Kong Airlines is what next: the carrier's network concentrates on funnelling mainland Chinese passengers, often in groups, to Southeast Asian destinations over Hong Kong. Regulators, traditionally conservative, permit Hong Kong Airlines to add only a few more aircraft under its current licence.

Hong Kong Airlines is attracted to long-haul growth - although this could conflict with sister carrier Hainan Airlines - but first must tidy its house to take advantage of low hanging fruit necessary on short-haul routes. Hong Kong Airlines needs more partners, strategically (to support frequent flyer loyalty) and financially (providing a secondary connecting option to Cathay in the Hong Kong hub).

Hong Kong Airlines, which does not have a strong local brand, is being usurped by its smaller sister carrier HK Express, which is now a LCC flying to popular destinations such as Seoul and Tokyo and achieving a clear Hong Kong identity. Media reports suggest Jetstar Hong Kong, announced almost three years ago in Mar-2012, will finally receive a hearing in 2015. Local airlines remain united against its entry.

Despite a number of well known markets in North Asia, the region's fastest growing major airport is actually Taipei Taoyuan. Taiwan's most significant airport, Taoyuan grew passenger numbers by 10% in 2013, with traffic in the first seven months of 2014 up a staggering 29%.

Growth well above Taiwan's GDP in the low single digits is due to a number of factors. Cross-Strait flights are increasing, with the market still far from saturation; LCCs from both Southeast and North Asia are inundating the airport, and local main carriers China Airlines and EVA Air are growing local and connecting traffic.

A recent Japan-Taiwan open skies agreement continues to have positive effects. EVA Air has emerged as a quiet but notable player in the trans-Pacific market, with less success between Asia and Europe, while China Airlines is seeking to catch up to EVA by rejuvenating its long-haul fleet.

After having more than a dozen foreign LCCs enter Taiwan, the country is finally launching two of its own, making it the last major market in North Asia to have LCCs. Local majority owned JV Tigerair Taiwan launched in Sep-2014, conservatively entering the Taiwan-Singapore route served by one of its shareholders, Tigerair (Singapore). Further growth is planned to North and Southeast Asia, but it is unclear what the dual-brand strategy is with its other shareholder, Taiwan's national carrier China Airlines.

Nor is there clarity on the strategy between full service TransAsia and its planned LCC, V Air. (EVA Air remains uninterested in a LCC subsidiary.) If Tigerair Taiwan enters the Hong Kong-Taipei market as mooted, this will be the first time a LCC has operated on the world's largest international city pair.

Change has come relatively slowly to North Asia, but now the inertia has been overcome, there is no doubting the sincerity to innovate, from Taiwan's carriers establishing LCC affiliates to Asiana seeking a larger role for itself. But still many questions remain about the details. What is certain is that the change of pace is accelerating.

Responses will need to be faster, but there will inevitably be some mistakes, as there have been in other markets. Remaining agile and correcting errors - and seizing opportunities - without prejudice will ensure innovation at last replaces more traditional attitudes.