Open Skies Agreement Between U.S. and China? Not Anytime Soon

Includes: AAL, CPCAY, DAL, UAL
by: David Wolf

Secretary of Transportation Mary Peters was in town last week talking to Chinese officials about the possibility of setting up an open skies agreement between the U.S. and China. I think it's a great idea, and I'm personally looking forward to direct flights between Beijing and Honolulu. Nonetheless, for several reasons I don't hold out much hope for an agreement in the near term, despite the SecTrans' optimistic tone.

The good news is that cabotage - or the ability of a U.S. airline to carry passengers between points within China, or of a Chinese airline to carry passengers between U.S. cities - appears to be off the table. Cabotage creates serious domestic political opposition, and would do so on both sides of the Pacific. Leaving cabotage out of the discussions apparently helped US conclude their open skies agreement with Europe last month. Secretary Peters, apparently flush from that success, is now tackling a much tougher nut in China.

The SecTrans is Smart, but...
From what I hear from some of the reporters who had contact with Secretary Peters during her jaunt through China last week, she is one very bright lady. Indeed, in the words of one journalist, she stands out among the Bush appointees as a singularly intelligent, well informed, down-to-earth, competent administrator.

The one challenge she faces, however, is that she is, by both training and disposition, a highway engineer. This means that not only is she an outsider to the politics and peculiarities of the aviation industry, she is also more accustomed to dealing with government issues in a domestic (rather than international) context. Her experience dealing with the Chinese is, therefore, also somewhat limited.

So when she predicts that the US will see an open skies agreement with China within the year, and a framework for discussion within a month, she can, therefore, be forgiven for her optimistic assessment.

Because anyone with experience negotiating international agreements with the Chinese government knows that reaching any bilateral accord, much less something with significant potential impact on China's economy, is not a quick process. Things just don't move that quickly here, and they are less likely to in this case.

Anyone familiar with the grunt work involved in reaching a bilateral open-skies agreement also understands that this will be a very long process. One friend of mine, working for a major wire service, noted that when he spoke to a senior U.S. airline executive recently about the possibility of open skies with China, he noted that he did not expect significant progress for at least a decade.

There are lots of reasons why this is the case. Two of them immediately come to mind.

What is Hong Kong?
One of the biggest questions in the discussions is the status of Hong Kong and Macao in the agreements. If you exclude Cathay Pacific (OTCPK:CPCAY) and Dragonair from the discussions, open skies looks like a great deal for U.S. carriers, but not necessarily such a hot deal for domestic Chinese airlines. Short of a significant upgrade of the reputation and service offered by Chinese airlines on their North American routes, chances are the U.S. carriers would dominate the routes, at least taking the more profitable business and leaving the Chinese airlines to scoop up the leftovers.

On the other hand, if China managed to convince the U.S. to include Hong Kong and Macao, the tables would turn. All of a sudden, you could fly Beijing to Los Angeles, San Francisco, New York, Chicago, and DC on Cathay Pacific. That would allow CPCAY to take the cream, with the American carriers fighting the mainland Chinese carriers for everything else.

While the Chinese may not want it (ownership structures notwithstanding, there's no love lost twixt the mainland carrier and it's Hong Kong cousins), it would be a great tool to use to slow down negotiations and exact concessions from the US. Regardless of how the Chinese feel about it, the U.S. airlines certainly don't want to face CPCAY on what are rapidly becoming the most profitable routes in the business.

Are the Chinese ready for open skies?

Here is the real kicker. You have to assume that at some point there will be an open skies agreement between the US and China. You also have to assume that the US wants this, because they are driving the process at the moment. This means that the Chinese control the timing of the process.

So the real question is "When will it make sense for the Chinese to go for open skies?"

The short answer to that is "Not right now."

Apart from the obvious question of service quality, China's airlines aren't ready. Marketing is weak, the brands need pumping - even the liveries on the sides of the aircraft look like throwbacks to the 1970s. Domestic demand is rising quickly, and the companies are having to deploy most of the aircraft, pilots, and financial resources they can muster simply to handle local growth.

Keeping up with a sudden inrush of airlines who are much larger and more experienced airlines would swamp the locals, who would be unable even to match the growth in routes. If it happened today, would Air China, China Eastern, and China Southern be able to start direct service to another half-dozen US cities without stripping their networks of assets? Already China needs to find 11,000 new pilots and 2,500 new aircraft in the next 20 years just to keep up with organic growth. Competing under open skies would only add to this burden.

Give them an inch...
There are other reasons for the Chinese to want to go slow on open skies with the US.

For one, the Europeans would show up the next day demanding open skies for their airlines, too. They'd be followed by the Japanese, the Singaporeans, and nearly every country in the world. In other words, even if you don't think United (UAUA), American (NASDAQ:AMR), Delta (DALRQ.PK), Continental (NYSE:CAL), Northwest (NWACQ.PK), USAir (LCC), and Hawaiian could collectively deliver a mortal wound to the international services of China's airlines, you have to assume that adding the rest of the world to that burden isn't going to help. At the very least, international growth opportunities for China's airlines would be stunted, and this at a time when those services are desperately needed to help make ends meet.

Bottom line, as hopeful as Secretary Peters might be, if I were her I wouldn't count on making open skies happen with China before her boss leaves office in January 2009.