By Milton Kotler

Within the past year there have been very significant developments in the China’s Commercial Aircraft industry. AVIC 1 has announced its prospective launch in 2008 of the wholly owned and designed ARJ -21 70-90 seat regional jet airliner. Harbin has licensed the 50 seat ERJ145er regional turbo jet from Embraer that it will launch this year. Boeing has made plans for significant increase in China’s parts and components production.Wing flaps, doors and other components made in Xi’an will outstrip similar production in Witchita. Most significantly, Xi’an Special High Tech Zone is planning the construction of a firsdt stage 10 sq. kilometer Aviation Park, which will attract parts and components makers from around the world and become China principal trade platform for its future aviation industry. But where is this industry going. That is the $64 dollar question!

In market economies there is only one thing worse than a monopoly and that is a duopoly. Monopolies are intrinsically inefficient because regulated prices determined the scale of invested capital. As demand for monopoly goods grows, like electric power, demand outstrips supply, but capital for new supply cannot enjoy the value of new supply that it generates for customers. Hence, capital does not walk in. Access to adequate capital, political pressures, and national security may recommend a limited number of regulated monopolies. But these protections do come at a cost in economic growth. They are best applied wher no growth in indeed wanted. Mallinkrodt Chemicals in the U.S. has monopoly rights by the Federal Government to produce heroin morphine hydrocodone, which are needed for specialized medical procedures but must be kept out of the general marketplace.

Duopolies are worse. They appear competitive and elude regulation. Yet, having the benefit of large customer markets that depend on their products, they find it more profitable to collude than compete. Skirting anti-trust laws in a variety of ways tey divide markets, while generating PR about their death defying competition. This is the case today in the world’s aircraft industry. Two companies divide world demand for large aircraft – Boeing and Airbus. Two other companies divide world demand for regional aircraft – Embraer of Brazil and Bombardier of Canada. Neither set of companies intrude on the other’s territory. Boeing and Airbus produce nothing less than 100 passenger seat aircraft. Embraer and Bombardier nothing more.

Duopolies best persist in regulated markets. Airline deals are made and end-user consumers pay the price, either in high regulated ticket prices or flight infrequency. But once the market is deregulated or vastly enlarged airlines search in vain for lower cost aircraft in order to secure a profit margin while they expand their fleets to capture higher volumes either for competitive or public policy reasons.

Nowhere is this discrepancy between demand and supply as sharply experienced than in China. China is currently the largest customer market in the world for both medium, large and regional aircraft. Yet she has no production supply to purchase. She is paying a high price to as duopolistic market for her needs; while at the same time forgoing profits from sales to her own and other countries if she were in fact in a position to supply her own and their needs.

When the opportunities of great demand meet the potential for new supply, something new has to happen. The interacting forces of China’s military aircraft infrastructure, her decade of intensive investment in technology, her abundant human resources of scientific and technical worker skills and her own huge domestic market demand for new aircraft, an finally her available capital will come together to produce a new independent force in world aircraft production. She may accept the present industry segmentation and compete in regional aircraft production. She may also decide to compete in the medium to large aircraft arena. Or she may in fact find her place in the current model of world duopoly. Whatever the outcome the one thing that is certain is that China shall have a world-class aircraft industry.

The Market Today

Despite an aviation slump in the world, the prospects of China’s regional jet market are enormous. It is estimated that the demand for regional aircraft will exceed 600 in China in the next 20 years, and the market is about US$14.4 billion.

Current statistics indicate that 60% of China's flight routes range between 600 kilometers and 2,200 kilometers, and, on average, 80 per cent of flights carry fewer than 100 passengers.

Currently, China's national and international airliners are big aircraft with more than 150 seats. They are purchased from aircraft manufacturing giants such as Boeing and Airbus. Due in part to the larger size, the average yield rate in recent years on China’s airliners has been less than 60 per cent. Smaller, full yield planes can correct these inefficiencies.

In the world's major airline markets; about 30 per cent of the airplanes are regional airliners with less than 100 seats. In China, it is 12 per cent. Experts said the country is expected to demand about 600 regional jets, with 50 to 110 seats in the coming two decades. By 2020, China's passenger fleet will have 1,852 aircraft and the ratio of regional jets to the total fleet will rise from the current 14.7 per cent to 31.5 per cent.

"Transport by regional jets will become a new growth area of the country's civil aviation industry." Zhang Hongbiao, vice-minister of the State Commission of Science, Technology and Industry for National Defense, said that China would give top priority to the research and development of regional aircraft in the coming decades. Production of regional airliners is the best choice for the nation as the aviation industry currently lacks the capability to producing large passenger aircraft competitively, he said.

The Government has already announced plans to create preferential conditions for the use of regional airlines, A number of airports will be upgraded and around 36 new airports will be built within the next five years that are suitable for smaller planes. Civil aviation authorities will announce a reduction of airport construction fees for regional aircraft, in order to encourage the use of these smaller planes. ,.

To date, Chinese airlines have only 68 regional jets below 70 seats. By 2005, it is estimated that China will need a further 60 regional jets, and by 2015, more than 300 regional jets for greater short haul flight frequency and to serve areas of the countries that cannot otherwise be served by large planes.

Local Players
The current world supply of regional jets comes principally from two producers: Embraer of Brazil and Bombardier of Canada. China will compete with these players, principally with Bombardier, which is the more vulnerable of the two. Boeing and Airbus do not produce plans with under 100-seat passenger capacity.
China has been trying to become a major player in regional jet market for a long time. It has made substantial progress in recent years. In 2000, China Aviation Industry Corporation I (AVIC I), with a total asset of RMB 34.9 billion, launched the ARJ-21 project, budgeting about RMB 5 billion (US$602 million) to develop two versions of the aircraft - one with 75 seats and the other carrying 85 passengers.

This aircraft project has passed examination and has been approved. The trial flights will be conducted by 2005 and the jets will be sold by 2007. The ARJ-21 is the country's first regional passenger jet aimed at the fast growing domestic market and the overseas market. AVIC I plans to export 150 ARJ-21 planes in the next two decades. Although the aircraft will be designed in China, engines and other components are likely to come from outside sources.

China's bid to become a player in the regional jet market was boosted at Beijing Air Show in 2003 when orders were placed for 35 ARJ-21 planes. Multi-million dollar orders came from Shandong Airline, Shanghai Airline and leasing company Shenzen Finance.
On the other hand, China Aviation Industry Corp II (AVIC II) signed an agreement with the Brazilian aircraft manufacturer Embraer to jointly produce 30- to 50-seat ERJ145 turbofan regional jets. The first plane has already come off the assembly line. According to the agreement, Embraer will establish a joint venture with Harbin Aircraft Industry (Group) Co Ltd and Hafei Aviation Industry Co Ltd - two companies under AVIC II - in Harbin. The newly formed company, called Harbin Embraer Aircraft Industry Co Ltd, involves an equity investment of US$25 million.
The joint venture will be capable of producing up to 24 aircraft annually, and it plans to produce eight jets in 2004. The first ERJ145, produced by this company passed a 10-minute flight trial recently in Harbin, the capital of northeast China's Heilongjiang province. Chinese airlines have already placed 30 firm orders for the 30-50 seat aircraft, with a further 10 options.

Origins

China's civil aviation transport dates to the founding of the People's Republic of China in 1949. At that time China had only 12 small aircraft for civilian use. Since then, more than 1,400 cargo aircraft, passenger planes and multi-purpose aircraft of 30 types in eight series have been developed and manufactured in China. Through long-term efforts and experience, China's civil aircraft industry has acquired the basic capability of civil aircraft design, manufacturing, testing and certificate verification.

From 1987, China's civil industry has been making concerted efforts to separate company military functions from commercial products and services, and create an open commercial transport market with efficient administrative backup. The original China Aviation Industry Company (AVIC) was split into 2 groups – China Aviation Industry Corporation I (AVIC I), and China Aviation Industry Corporation II (AVIC II). AVIC I focuses on large- and medium-sized aircraft, while AVIC II gives priority to feeder airlines and helicopters.

On March 20, 1997, during the meeting between Premier Li Peng and Jean Pierson, the President and CEO of Airbus Industry Group, in Beijing, Mr. Li expressed the hope that Airbus will continue to co-operate with China and compete in the Chinese aircraft market. Co-operation between China's aircraft industry and Airbus in production of a 100-seat passenger plane is underway and initial progress has been made.

Attempts in earlier decades to produce regional jets failed due to the reluctance of the Chinese airlines to place orders. But in 1998 a group of six Chinese aerospace companies decided again to build regional passenger jets with either 58 or 76 seats and a range of up to 3,200 kilometers. The six companies were Harbin Aircraft Manufacturing, Xi’an Aircraft Industry Group, Shaanxi Aircraft Co., Shanghai Aviation Industrial Corp., Shanghai Aircraft Research Institute and the Xi’an Design and Research Institute.

The cooperation among these several companies has effectively driven the development of China’s regional jet. Each of the companies improved technology and manufacturing level through providing a wide range of parts and sub-assemblies to Boeing and Airbus. The general level of Chinese aircraft workmanship has risen significantly, as attested by growing sourcing orders.

Boeing’s industrial cooperation with China began in 1980, and currently there are approximately 3,300 Boeing airplanes flying worldwide that include major parts built by China. This represents 25% of Boeing’s total commercial fleet. Shanghai Aviation Industrial Corporation (SAIC) monthly turnover of vertical fins for the Boeing 737 has reached 13 sets, Xi’an Aircraft Industry Group has reached 10 sets, and Shenyang Aircraft Corporation’s is producing 8 sets. SAIC was designated by Boeing as a Golden Supplier and offered membership in the of Quality Control Group. This indicates that Chinese aircraft manufacturers have added technology competitiveness to low cost production.

In addition, European aircraft manufacturer Airbus is moving its wing production and assembly base to China over the next seven to ten years, China Daily said. Airbus China president Guy McLeod told the newspaper that trial installation in the UK of wing parts manufactured by Shenyang Aircraft Co and Xi’an Aircraft Co demonstrated the high technical capabilities of Chinese manufacturers.

Obstacles to Regional Jets

Though there is a big potential market and demand for regional jets within China, the aviation manufacturers will find that there are hurdles to win some big orders in the short term, both from within and without.

In spite of China’s preferential policies for the use of domestically manufactured regional airlines, most Chinese airline companies are not very positive about purchase. There is still a hangover from China’s safety record two decades ago when she was using Russian designs. Also, Chinese airports charge the same landing and maintenance fees for all commercial airplanes, regardless of how many seats they have. As a result, regional jets' per-seat costs for landing, maintenance and storage are much higher than those of big airliners, such as the Boeing-747.

Most Chinese airlines have purchased Boeing and Airbus aircraft and have developed mature technical teams and maintenance networks. Introducing new large domestically manufactured planes to their fleets might mean added maintenance costs.

Unreasonable flight routes in China are also impeding the use of regional jets. China's three State-owned airlines -- Beijing-based Air China, Shanghai-based China Eastern Airlines and Guangzhou-based China Southern Airlines - get to chart their own routes. Considering their profits, the three air groups prefer to develop long-distance air routes to and from Beijing, Shanghai and Guangzhou. Regional airlines should have been major customers of short-range aircraft, but they do not have enough landing rights to develop many regional air routes. Analysts say the difficulty in developing regional air routes has forced Hainan Airlines, China's fourth-largest airline, to shift its strategy from a regional air company to a long-distance airline. In spite of these obstacles, lower operational costs will help make regional jets popular over the long term.

In addition, the restructuring work in China aviation industry may defer the government’s move to drive the market for regional jets. China’s aviation industry is a complex and often confusing web of ministry-level entities, state-owned firms and semi-independent companies. There are a significant number of independent and semi-independent aviation trade corporations, manufacturers, and business groups that do not answer to ministry-level organizations like the Civil Aviation Administration Of China or AVIC for their everyday operations. Moreover, municipal governments have assumed more control over aviation in their regions, and foreign cooperation is increasingly handled through individual enterprises rather than through government organizations.

Hafei and other industry players are lobbying the government to work out more beneficial policies to develop regional jets market. But Currently, policy-makers are mainly concerned with the restructuring of the air industry.

Maybe after that problem is resolved, development of China's regional jets market will become the priority, and the current reform and consolidation in the Chinese airline industry will lay a solid foundation for the rationalization of the airline networks.

Industrial Backbone

Shaanxi Province provides one-third of China’s aircraft resources. Its current manufacture, design and flight testing capability is awesome. China Aviation Industry Corporations I (AVIC I) s a big organization with 53 large- and medium-sized industrial enterprises, 30 research institutes, and 30 specialized companies and institutions under its umbrella, employing a total of 236,000 people throughout China. The total asset is RMB 34.9 billion.

As a general rule, AVIC I is mainly engaged in the development of military & civil aircraft above 30 seats. It also produces aero-engines, airborne equipment and weaponry system. It has a wide-ranging portfolio of non-aviation products produced by its factories. Partly this is a result of its formation - combing various provincial enterprises into one entity.

AVIC I includes some famous aviation manufacturers in China, like Chengdu Aircraft Company, Xi’an Aircraft Company, Nanchang Aircraft Company, and Shenyang Aircraft Company. Parts for Boeing jetliners and other non-Chinese aircraft are made at these facilities. Shenyang Aircraft Corporation (SAC) has formed a joint production venture with Boeing for producing whole tail sections and cargo doors. SAC in the past has done work for British Aerospace, Airbus, and Lockheed, and currently has a manufacturing sub-assembly venture with Canadian Bombardier Aerospace. Chengdu Aircraft Company is under contract with Northrop Grumman to produce 757’s empennage (horizontal stabilizer, vertical fin and tail section) for Boeing. Chengdu Aircraft Company has been involved in manufacturing parts for Airbus aircraft as well as maintenance tools. Xi’an Aircraft Company (XAC) took its first step in international aviation cooperation in 1980, and has successively cooperated and manufactured some aviation components with many world famous aviation company from America, Canada, Italy, France and Germany. Major assemblies co-produced at Xi’an Aircraft Company include 737 vertical fins, horizontal stabilizers, forward access doors, and 747 trailing edge ribs. Boeing also contracts with plants in Xi’an for aluminum and titanium forgings. In May 1997 Airbus signed a contract for the manufacturing by Xi’an Aircraft Company of the rear section of the fuselage for the ATR 72 twin-turboprop 74-passenger aircraft.

The human resources in Xi’an and Shaanxi Province that are applicable to the aircraft industry are awesome. There are over thirty universities and research institutes with 900,000 university students and nearly 300,000 aircraft industry workers.

Most notably AVIC 1 will be the anchor of the the new Xi’an Special High Tech Zone Aviation Park, which is initially planned for five sq, km, with early expansion to 10 and ultimately to 40 sq. km. This park will attract aviation parts and component makers from, all over the world and will provide the critical mass for China’s expansion into large aircraft production.

China Aviation Industry Corporation II (AVIC II) owns 54 large- and medium-sized industrial enterprises and 3 scientific research institutes involved in helicopter, airplane, engine and airborne equipment. They control an additional 22 enterprises, institutes and specialized companies including China Aviation Industry Supply and Marketing Corporation. They employ 210,000 workers, and control assets of RMB 31.5 billion.

Last year, the corporation turned out RMB 28 billion (US$3.4 billion) of industrial output and achieved sales income of RMB 20.2 billion (US$2.4 billion), - an increase of 29.4 per cent and 22.1 per cent respectively from 2001. It earned RMB 20 million (US$2.4 million) in profits. By 2005, the annual industrial output of AVIC II is expected to reach RMB 36 billion (US$4.3 billion). The annual sales income is likely to hit RMB 26 billion (US$3.1 billion). The corporation's profits are expected to reach RMB 300 million (US$36.1 million) by then.
It currently has joint cooperation with Egypt and Canada to export 200 Y-12 aircraft. K-8E aircraft is the first whole-set technology export of China’s aero-products. AVIC II is also operating a 30-seater regional jet project in China.

At the Paris Air Show 2001, AVIC II signed MOU with Snecma in France, and with Rolls-Royce International Ltd to include 250 C20R engines as one of the choices used to refit the Z-11, 2 ton class helicopter form single engine to double engines. Subcontract value amounted to USD29 million in 2000.

The Future of large Aircraft

In the 1980s China cooperated with McDonnell Douglas to produce a 707 with over 100 passengers. Ultimately that cooperation resulted in only two planes before Boeing bought our McDonald Douglas and terminated the Sino-U.S. partnership. China continued to produce its earlier Russian large aircraft products with their poor reliability and safety performance, until its modernized passenger airlines replaced the earlier fleet with world class Boeing and Airbus large aircraft.

The market is a mighty force and China’s demand for large aircraft, as well as regional jets, will eventually force her into a long-term program of medium and large aircraft design, development and construction. China will eventually have its own 737, 767 and 747. It is a matter of time and market opportunity. The country has all the three fundamentals of entering the medium and large aircraft manufacture marketplace. 1) China is becoming one of the largest domestic and international airline passenger markets in the world. 2) It has the largest demand for regional, medium and large aircraft in the world. 3) China’s military aircraft infrastructure gives its commercial industry a technology, design and scale advantage that no other third force in the world enjoys, after the U.S. and Europe. 4) Abundant capital for investment is available in a market of immense unit margin profit and volume. 5) Aviation and auto production are the big ticket, fixed investment industries that drive China’s export growth for another three decades. 5) China has an unparalleled human resources pool of engineers and aerospace scientists that is superior to any other third force that might wish to enter the global medium and large size aircraft market. 6) An eventual cluster of all relevant aircraft parts and component manufacturers in the Xi’an Aviation Park will support the efficient expansion of the Chinese commercial aircraft industry. 7) China high tech, low cost development and manufacturing can beat the duopolistic pricing of Boeing and Airbus.

The Reconfiguration of the World Aircraft Industry

What will eventually happen in the world of medium and large aircraft production? Today Boeing is in a heap of trouble. Its current ethics scandal concerning the 767 has dealt a grievous blow to future production. The company, already heavily in debt and badly trailing the Airbus A380, has decided nonetheless to spend new billions to develop the new 7E7 with only two orders on the books. After decade as a commercial aircraft company, Boeing made a strategic decision to diversify its business model and enter the field of military development and manufacture. That arena is now almost co-equal in revenues with its commercial aircraft operations. There is real uncertainty whether Boeing with have enough capital resources and marketing focus to compete with Airbus in the commercial sector, while at the same time competing with Lockheed and Grumman in the military sector. How far with the U.S. government go to underwrite commercial support, and how will these indirect supports impact allegations of unfair trade policy.

It is not 100 per cent certain that Boeing can remain viable in the commercial aircraft sector. This opens the door to Chinese strategies of partnership and even merger. While China may choose to evolve as an independent third force in the global industry, it is not impossible that we may see a merger of the commercial side of AVIC 1 with Boeing’s commercial aircraft side in not too distant future. Boeing could then share the profits of a Sino-U.S. company in the China and global markets with superior aircraft at prices that Airbus would have difficulty to match; which building its strength on the military side.

For skeptics, who may think this prospect is absurd, take heed of last week’s acquisition of Air Canada by Victor Li, nominal Canadian, Hong Kong resident and Chinese man. If one had predicted five years ago that Hong Kong and Chinese interests would acquire Air Canada, they would have been pointed to the loony house. Not so today. Nothing is impossible for China’s industrial and marketing might in the future.