Despite China’s rapid economic growth, the air cargo sector has proven a bumpy ride for many fi rms, and there’smore turbulence ahead.

China’s economy has transformed radically in the past three decades: annual GDP growth has averaged 9% since reforms began in 1978, and in the past fi ve years alone, the value of China’s exports has nearly quadrupled, reaching$1 trillion in 2006.

Chinese factories have progressed from supplying worldwide markets with parts and basic materials to producing sophisticated, high-tech goods that are natural candidates for shipment via air cargo. This economic boom has led to Chinese air cargo throughput growth of more than 11% per year over thepast decade.

Cargo demand to and from China is shaped mainly by a growing trade surplus with the U.S. and Europe, trade defi – cits with Asian neighbors (collectively China’s largest trading partner), and increasing domestic trade fl ows. Given increasing liberalisation, this rapidly expanding market appears to offer rich opportunities for foreign cargo carriers, but it also poses several strategic challenges:

China’s cargo sector is changing at an astonishing speed, owing to a confl uence of consolidation, market liberalisation, and foreign carrier entry. Aviation infrastructure has constrained capacity that lags demand.

The unbalanced nature of China’s trade fl ows (noteworthy in a region known for asymmetric fl ows) signifi – cantly dilutes the economics of freighteroperations.

Carriers seeking to operate in this market must address these challenges, and can reduce their risks through a careful assessment of strategic options to pursue, such as what hubs, routes, partners, and partnership mechanisms may offerthe best value.

The Coming Wave of Consolidation
Beyond robust economic expansion, China’s cargo landscape has been punctuated by three major trends: consolidation, market liberalisation, and the growth of integrators, leading to intensifying competitionand pressure on yields.

In 1990, there were more than 20 regional airlines in China, most of them suffering from capital shortages, inadequate infrastructure, low service levels, and continuous price wars. Today, after a government-induced wave of consolidation in the late 1990s, only a few leading airlines remain– Air China, China Eastern, and ChinaSouthern; plus a few regional airlinessuch as Hainan Airlines, Shanghai Airlines,Shenzhen Airlines, and ShandongAirlines.

We believe that a second wave of consolidation is likely to occur over the next two years, this time among Chinese air cargo carriers. In recent years, these airlines have invested heavily in network expansion and added capacity, but all are facing increased foreign competition and some are experiencing substantialoperating losses.

Air China Cargo’s proposed merger with China Cargo Airlines, sparked by the takeover of Dragon Air by Cathay Pacifi c, provides an early indication of this impending wave. Cathay is currently the only international carrier with domestic routes in China – although the ongoing wave of joint ventures will likelychange this.

Adding to these pressures, revised regulations on foreign investment in the aviation industry, effective August 2002, have generated a voracious appetite for foreign investment and joint venture activity in the sector, even no fi rm hasrealised success yet.

Jade, Great Wall, Grand Star, Yangtze, and other intended and realized joint ventures – as well as recent passenger alliance courtships – illustrate strong foreign demand for access to the Chinese market. U.S. carriers also have been snapping up traffi c rights as soon as they become available. For instance, this intensifying competition is clearly noticeable at Shanghai, China’s largestcargo hub, as shown in Exhibit 1.

Finally, the “Big Four” integrators– DHL, UPS, FedEx, and TNT havecornered nearly 90% of the expressmarket. The growing scale of integratorswill challenge those air cargo carrierswho continue to rely on belly space forcargo. To protect market share, localfreight forwarders will need to adapt andcompete more effectively or may need tojoin forces with external partners.The combined impact of the changesdiscussed here has been acute. Manymarket participants complain of significantovercapacity and downwardpressure on yields – even out of pastsurefi re markets like Hong Kong. Whileexport demand out of major mainlandChinese markets remains strong, yieldsare crumbling there as well.

Constraints on Infrastructure Growth
The largest Chinese airports are constrained on capacity: Shanghai airports face increasing pollution and declining ground space for customers. Pudong experiences an average of 40 foggy days per year. Tianjin Airport, designated in 2002 primarily for cargo transportation, lags considerably behind Beijing in international connectivity, leaving the Beijinggateway continually stretched.

As with other rapidly growing economies, China’s infrastructure growth has lagged for several reasons, although once underway, projects get completedfast.

Of late, public activism has slowed many public projects, with China’s middle more sensitise to the environmental side effects of infrastructure development. Owing to infrastructure constraints, related costs for carriers have been increasing. For example, Shanghai now ranks eighth among the world’s airports in landing fees for 747-400aircraft.

Air cargo also faces modal challenges. China Railway Express has launched dedicated express cargo trains between large cities such as Beijing and Guangzhou to compete with air cargo. For the domestic operations of Chinese carriers as well as for joint venture carriers, this is a viable, emerging competitivethreat.

The Impact of Trade Imbalances
Trade flow imbalance creates excess capacity on the import side, as freighters return empty to serve high-demand export segments. These “dead” segments, combined with weakening yields on exports, canrender freighter operations uneconomical.

Minimising dead segments is a complex network optimisation challenge, involving tactics such as improving the use of a carrier’s traffi c rights, sharing traffi c rights across partner carriers, and accessing the networks of partnerairlines.

The Key Questions for Managers
Carriers aiming to expand profi tably in China’s air cargo sector should address four questions around theirstrategic options:

1. Which hubs should we pursue?
Among the major hubs, Beijing Capital, Shanghai Pudong, and Guangzhou’s new Baiyun are the top three airports in China. They are situated along the coast, which is China’s most prosperous region and which has the highest air cargo traffi c volumes. Hub carriers include Air China, China Eastern Airlines,and China Southern.

A fourth airport, Shenzhen, located in Southern China, ranks fourth in cargo throughput. It has achieved an 18% annual growth rate over the past fi ve years. The region has the second-highest GDP in Southern China after Guangzhou, and a strong manufacturing base. Jade Cargo, formed by Lufthansa and Shenzhen Airlines, is based in Shenzhen andindicative of the city’s important role.

Second-tier airports present slightly different opportunities. Wuhan is considered a strategic location, within an hour’s fl ight from many major economic centers in Eastern China. Since 2000, cargo throughput has grown annually by 12%. This will be further boosted by CAAC’s plans to develop Wuhan into the country’s fourth major hub, after Shanghai, Beijing, and Guangzhou– and in competition with Shenzhen.Wuhan also is a test city for China’s aviationreform initiatives, receiving morethan US$400 million for expansionand connectivity. And Wuhan permitsdirect international service.

Tianjin’s low-cost base and proximity to Beijing (an hour’s trucking distance from Beijing airport) is attractive to pure cargo operators and integrators and has already been spotted by Grand Star Cargo.

Shenyang is a traditional industrial base in the northeast of China. The government has developed initiatives to revive its leading position as an industry and logistics hub. Its GDP grew by 16% in 2005. Proximity to Korea and Japan make it a strategic location for service to North Asia.

Finally, some third-tier airports may prove attractive as transfer points for specifi c trade routes. While these are not likely to be primary targets for foreign carriers, their locations may be attractive to carriers operating Europe- China and Southeast Asia-China routes. Such airports include Kunming for its proximity to Southeast Asia, Urumqi for its proximity to Russia, and Chengdu and Xi’an for their location at the center of China’s east-west trade route.

2. Which trade lanes should we pursue?
Given China’s trade imbalances, carriers should select routes that minimize dead sectors, particularly for freighter operators, but also for belly-only carriers wanting to improve cargo profi tability.

For freighter operators, minimizing dead sectors will involve tracing routes across countries where they have traffi c rights and where they can capture a meaningful share of trade fl ow to and from China. For belly-only carriers, alliances and partnerships can be used to balance fl ows by adding directional capacity via code shares, blocked space agreements, or wet-leasing of freighters.

3. How do we find a good partner?
The game board of Chinese cargo carriers changes rapidly. Finding an appropriate national or regional player that can provide access to desired hubs will require considerable due diligence.

Evaluating a partner must go beyond geographic coverage to include a good match in terms of operational and management practices. As supply chains integrate globally, global cargo carriers cannot afford to have their service quality compromised by a weak partner on the fi rst or last leg. Successful partnerships will hinge on IT capabilities and operational processes that support seamless information fl ows.

Alternatively, a carrier may decide to pursue a “passive” partner, which can provide greater freedom in terms of building operations, IT, and brand to its own liking and standards.

4. How do we pursue a target hub and/or partner?
Options for pursuing opportunities in the Chinese air cargo market include alliances, joint ventures, and strategic investments. Despite liberalization and the willingness of Chinese and foreign carriers to pursue joint ventures, the success rate of such ventures to date has been moderate.

Negotiations can take from a few months to several years. Typical hurdles include cultural differences, regulatory scrutiny by Chinese and foreign governments, and the nature of China’s relations with the concerned foreign states. Against this backdrop, selecting the right partnership mechanism will be just as critical as selecting target hubs, routes, and partners for aspiring entrants.

Summary
A booming air cargo market and a more relaxed regulatory landscape are opening up new opportunities for national and foreign carriers. China will continue to be a critical nexus in global trade fl ows. The government has committed to strengthening and liberalizing the cargo sector, and domestic carriers are receptive to foreign partners.

China’s cargo sector, however, is undergoing such rapid change that it is a moving target for foreign carriers. The risk and consequences of miscalculation can be daunting to managers. While aspiring entrants may be tempted to seek the quickest or easiest access to this booming market, carriers will be better served by taking a long-term view. Methodically charting a China strategy will reduce risks and improve the odds of creating a viable, sustainable business model.

About the authors Andrew Watterson is a director in the aviation practice of Oliver Wyman, a global management consultancy. Niko Herrmann, Raj Lalsare and Ellen Hu are principals in the group. They can be reached at [email protected], [email protected], [email protected], and [email protected], respectively. Joyce Chan of the Hong Kong offi ce also contributed to this article.