Determining the impact of the China factor

As China moves through a massive shift in its economic gears, opinions differ about the influence the Mainland’s root and branch fiscal restructuring will have on the region’s airline industry. Mixed in the short term, but positive in long run, predict analysts.

by CHIEF CORRESPONDENT, TOM BALLANTYNE  

June 1st 2016

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After a near disastrous start to the year and a short lived recovery in March, the Chinese economy is once again heading in the wrong direction. Read More » For the economic pessimists, the Mainland’s growth is moribund and there is not much that can be done about it.

In their view, a contraction is certain and a severe adjustment downward - in common parlance a crash – is inevitable.

It is the kind of talk that tests the convictions of airline managements as they decide on strategies to expand in this huge market. If China’s economy continues to decline what will be the impact on the economies - and therefore air traffic growth - in the region and the world?

As media commentary makes clear daily, there are divergent views about China’s economic health. For every pundit bearish on China there is another with the opposite view.

At the heart of the debate is the credibility of China’s economic data. The Mainland’s National Bureau of Statistics reported that growth in the first calendar quarter of 2016 was 6.7%, slightly off the figure of 6.9% for all of last year.

Some economists believe 6.7% is simply too good to be true. They suspect China’s official statisticians are fiddling the books. True or not, these sceptics compound doubts about the state of the Mainland economy, particularly when the country has a $30 trillion debt.

In May, David Oxley, a senior economist at the International Air Transport Association (IATA), said at the release of an Oxford Economics and IATA report, The Outlook for the Global Economy and Air Passenger Flows, that there are well documented concerns about the accuracy of the official Chinese Gross Domestic Product (GDP) rate of 6.5%.

But he said the bigger picture about China in recent months “is that some of the gloomiest fears of a hard landing seem assuaged and there appears to be degree of stabilization in the economy”.

It is a view also held by the International Monetary Fund (IMF), with its managing director, Christine Lagarde, telling a recent forum in Dubai that the global economy is in a “tepid” recovery, but China’s deliberate slowing of economic growth will not lead to a “hard landing”.

Lagarde said despite the fact that the IMF recently lowered its forecast for global growth to 3.4% for 2016 and 3.6% in 2017, in part because of the Chinese slowdown, the revision also was due to lower commodity prices and strains in large, emerging economies such as Brazil.

“We, the IMF, don’t believe China is going to have a hard landing. We see it as a deliberate transition. It also is a big transitional business model that is essentially moving from heavy manufacturing to lighter manufacturing and a lot more services. It is going from investing to much more consuming and is being a bit less predominately export-driven,” said Lagarde.

Others are even more optimistic. IATA director general and CEO, Tony Tyler said “the overall Chinese economy has slowed down, but air travel in China has remained quite robust”.

Oxley had another important point to make. “For China, notwithstanding all the doom and gloom on the macroeconomic side, the air passenger market has been relatively unperturbed,” he said.

“The upward trend in the market has continued. This partly relates to ongoing signs that the services sector in China is holding up relatively well. A lot of the economic weakness appears to have been confined to the more industrial side rather than the services part of the economy, which matters more for air transport.

“There has been a lot of stimulus from network expansion in China. In 2015, there was an 8% increase in direct city routes operated within China, which again translates into time saving for passengers and helps to induce demand.”

Another factor emerged in the Oxford Economics/IATA report. China, while clearly important, is not the sole driver of regional economic and aviation growth. India is now the world’s fastest growing emerging market.

Oxford Economics forecasts air traffic in China will grow at 8.3% each year to 2021, but over a 20-year period it will settle down to an average of 5% per year. Whatever happens in China, it is forecast that air passenger journeys across the region will average growth of 4.6%. By 2035, the Asia-Pacific will have 1.76 billion passenger journeys every year.

To understand the size of the region’s market, the study looked at forecast expansion in other regions. In comparison, North America will have 545 million passenger journeys and Europe 462 million by 2035. In the Middle East and Africa, despite having similar percentage growth to the Asia-Pacific, the two regions’ passenger numbers will only be 236 million and 156 million journeys, respectively, per year by 2035.

Big plane makers also sweep aside concerns about China’s slowing economy. Boeing and Airbus continue to see China as their most promising future market. John Leahy, chief operating officer, customers at Airbus expected double digit growth in aviation traffic in China every year. Airbus president and chief executive, Fabrice Bregier, has said: “We don’t see the slowdown. Our competitors don’t see it. Our customers don’t see it. We have never been so happy.”

'We, the IMF, don’t believe China is going to have a hard landing. We see it as a deliberate transition. It also is a big transitional business model that is essentially moving from heavy manufacturing to lighter manufacturing and a lot more services. It is moving from investing to much more consuming and being a bit less predominately export-driven'

Christine Lagarde Managing director International Monetary Fund

Boeing forecasts Chinese airlines will need 6,330 new planes, worth $950 billion, in the next two decades, which is 17% of the global total. Airbus expected China to require about 5,400 new planes, which will be 40% of deliveries for the Asia-Pacific.

Chinese airlines themselves are demonstrating no fear of a downturn in their businesses. In the past six months, orders have been rolling in at Boeing and Airbus. China Southern Airlines has ordered aircraft from the two big manufacturers, worth $13 billion. Chinese Eastern Airlines has agreed to purchase 20 A350s and 15 B787 Dreamliners, worth $10 billion at list prices.

In 2015, Mainland airlines and leasing companies announced orders for 780 planes, valued at about $102 billion, hardly a sign they see trouble ahead.

Another indication that the Mainland’s economic slowdown needed to be separated from the region’s air traffic landscape comes from Fitch Ratings in New York. In March, the agency said it expected economic growth deceleration in China to 2017, but that the downward trend should not significantly hurt aircraft lessors’ credit profiles.

The market value of leased aircraft in China is $34.3 billion according to Ascend, which is approximately 17.1% of leased aircraft globally. Of the 44 lessors with exposure to China, the largest, on a notional basis, are ICBC Financial Leasing, AerCap Holdings, GE Capital Aviation Services, CDB Leasing and Bank of Communications Finance Leasing. Chinese lessors, who almost exclusively lease their planes to Chinese carriers, are playing an increasing role in the leasing sector.

“While the Asia-Pacific is a meaningful area of current exposure for most aircraft lessors, we expect that resilient consumer spending in China in the next few years and the Chinese government’s support for top airlines - that are among the lessors’ top customers - should suppress the fallout from a broader China slowdown,” said Fitch.

It added the aviation industry is cyclical, tied to passenger travel and therefore driven in part by consumer spending. The last time China experienced a marked GDP decline was in 2012, when it fell to 7.7%, from 9.3% over the previous year.

At that time, China experienced a 1.40% decline in aircraft revenue passenger kilometer (RPK) growth, according to IATA, and a 1% falloff in average cumulative hours traveled by passengers in China.

“We believe that a similar dynamic of moderate RPK growth could play out over the next few years as the secular drivers of Chinese air travel, namely a growing middle class, low jet fuel prices and airlines’ increased use of leasing persist,” said Fitch.

Another factor driving air travel is that China’s population is more than three times larger than the U.S., but Chinese aircraft values represent approximately two thirds of U.S. aircraft values, said Ascend.

Recent Chinese airport infrastructure investments also supported air passenger traffic, which grew 10.9% domestically in 2015, said IATA. In 2016, China will invest $11.9 billion in building aviation infrastructure, Xinhua news agency reported, based on information on the Civil Aviation Administration of China (CAAC)’s website.

The CAAC said the investment would focus on airports, which will lead to 11 key construction projects and 52 aviation-related upgrades to existing facilities. The government is encouraging air travel by building 66 airports during its current five-year plan.

It also should be kept in mind that China is not alone in experiencing a slowdown. Most global economies are fragile, with the healthy surge in air traffic experienced in recent years showing signs of easing worldwide.

Last month, IATA released its latest monthly data for March, which showed demand measured in revenue passenger kilometers (RPK) rose 5.3% compared with the same month last year. Capacity grew slightly faster, at 5.9%, which pushed the average load factor down by half a percentage point, to 79.6%.

It is a moderate slowdown on the year-on-year growth rates recorded in January (7.2%) and February (8.6%), even after adjustment for the leap year impact in February. Demand for international traffic grew significantly more quickly, at 6.2%, than for domestic travel (3.7%).

“While in line with long-term trends, demand growth in March represented a slowdown compared with January and February. It is premature to say if this marks the end of the recent very strong results. We do expect further stimulus in the form of network expansion and declines in travel costs. However, the wider economic backdrop remains subdued,” said IATA’s Tyler.

Asia-Pacific airline traffic rose 6% in March compared with the year-ago period. However, capacity increased 7.8%. As a result, load factor dropped 1.3 percentage points to 77.4%.

Domestic demand rose 3.7% in March over 12 months ago; a dramatic slowdown from the leap year aided 7.8% growth recorded in February. “This was driven primarily by performance in the two largest markets, the U.S., which accounts for two of every five domestic passengers, and China,” said IATA.

IATA’s Oxley said recently there had been a rotation away from global growth being driven by emerging markets, particularly the BRIC (Brazil, Russia, India, China) bloc. “In fact, we have seen emerging market growth, in aggregate, slow in each of the past five years,” Oxley said.

“This partly relates to the well documented slowdown in the Chinese economy, but if you exclude China there also has been a very broad spread in slowing in other emerging markets, not least in those countries heavily dependent on energy and commodity revenues.” Brazil and Russia are almost in free fall, with their GDP declining significantly.

“The key thing to consider,” said Oxley, “is that unlike the situation in 2008-2009, when emerging growth slowed and then bounced back very strongly, the same thing is not happening this time around. We are not expecting this to be a one-off.”

Despite the divergence of opinion about the Mainland’s economic future, it is important to remember that Asia-Pacific airlines don’t have all their eggs in the one basket of China.

They may see China as an area of primary market focus, but the region’s biggest airlines are global operators. They fly to Europe, North America, South America, Australasia and within Asia.

They are innovative and react quickly to changing market conditions. Most observers agree that if there was a serious downturn in China – and that is far from certain, particularly in terms of air traffic – Asia-Pacific airlines would weather that storm, as they have weathered all the other storms in their long operating histories.

No hard landing for China’s airlines says Asia’s industry association Director-general of the Association of Asia Pacific Airlines (AAPA), Andrew Herdman, said robust passenger demand is continuing in the region, despite concerns about the global macro-economic outlook. “Low oil prices have certainly helped, leading to widespread availability of affordable airfares, which have added stimulus to the market,” he said. “China seems to reflect similar dynamics, with the services sector still thriving in contrast to a marked slowdown in manufacturing and exports. Air cargo markets remain weak, with minimal growth in demand and latent over-capacity maintaining downward pressure on yields.” In China, Herdman said, continued growth in passenger demand meant that concerns remain on the supply side, with crowded airspace and slot scarcity constraining route development, even though aviation authorities are improving airspace utilization. “Pilot shortages are another concern for Chinese airlines. They are being addressed, at least partially in the short term, by hiring a growing number of foreign pilots,” he said. “In addition to steady growth in the domestic market, Mainland airlines have expanded their international business with new trans-Pacific services and greater frequencies to popular Asian destinations. “Overall, the outlook for growth in passenger demand remains quite positive although the pace may moderate somewhat as oil prices regain some lost ground from the earlier lows.”