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Chinese airlines fly into headwinds in Olympic year

SHANGHAI - It was supposed to be Air China's year: the airline heralded a new era in Chinese aviation by joining Star Alliance, became the Olympics official carrier and expected big passenger numbers to follow.

However, disasters, a shaky economy, rising fuel costs and falling demand bedevilled Air China and other Chinese carriers, turning a year that began with optimism into one filled with turbulence.

‘2008 is an unusual year. China and Air China have met unprecedented challenges,’ Air China Chairman Kong Dong said last week as the carrier announced a 20.7 percent fall in first half net profit.

The year began with blizzards paralysing parts of the country during the Spring Festival, China's peak travel period, then unrest in Tibet led to a 70 percent drop in visitors to the region, and finally, the southwest was hit by a massive earthquake in May -- the worst natural disaster in a generation.

The Olympics also proved disappointing for airlines since the government imposed stricter visa policies and beefed up security, prompting many Chinese and foreigners to stay home.

In the past few days, China's three biggest airlines gave a first glimpse of how bad a first half it has been. Air China's profits fell to 1.2 billion yuan (182 million dollars), while China Eastern Airlines saw a net loss of 212.5 million yuan.

Airline bosses warn they do not expect clearer skies anytime soon.

‘The airline industry, with weakening traffic demand, increasing competition and high oil prices, faces a long, severe winter,’ warned Liu Shaoyong, chairman of the country's largest carrier, China Southern Airlines.

Years of rapid industry growth seem to have halted as China's big three airlines were hit by the abrupt drop in passengers.

‘High oil prices and the global economic slowdown will undoubtedly continue to affect the aviation industry for the rest of the year, and we might also be impacted beyond 2008,’ Air China's Kong said in a statement.

Although analysts expected gradual traffic growth post-Games, they warned there was more to the deceleration than one-off events.

Economic growth in China slowed to 10.4 percent in the first half of 2008, down from 11.9 percent for all of last year.

‘The overall demand in the aviation sector is slowing down. Domestic passenger volume can no long sustain annual growth of 16-20 percent as it did over the past few years,’ said Xia Fulu, an analyst with Industrial Securities in Shanghai.

Chinese airlines saw a combined 5.4 percent growth in first-half passenger volume, far short of the regulator's full-year forecast of a 14 percent increase. It is also down significantly from last year's 16 percent growth.

Meanwhile, rising oil prices are eating away at carriers' already thin margins.

‘While low revenue growth was dragged down by overall traffic slowdown, surging jet fuel cost in the first half of 2008 has driven up total operating costs,’ said Edward Xu, a Hong Kong-based analyst with Morgan Stanley.

China Southern has announced plans to cut operating costs by 1.3 billion yuan, including a ten-percent pay cut for managers.

However, the airlines' losses were cushioned by a rise in the Chinese yuan that made it easier to pay off US dollar-denominated debt for buying and leasing aircraft.

‘Eliminate the effects of a stronger yuan and you will find out their core business is bleeding,’ Xia said.

The benefits of the rising yuan are best illustrated by China Southern, whose net profit jumped fivefold to 847 million yuan in the first half thanks solely to currency gains.

It booked foreign exchange gains of 2.6 billion yuan for the period, more than double its wider first-half operating loss of 1.17 billion, as the yuan rose 6.6 percent in the period, nearly as much as it did in the whole of 2007.

Analysts suggested the industry turmoil could lead to consolidation, a move regulators shied away from in the run-up to the Olympics to maintain industry stability.

China Eastern is seen as most vulnerable, given its poor financial position.

A preliminary deal that would have seen China Eastern sell a 24 percent stake to Singapore Airlines expired in August, but the carrier said it would continue to seek strategic investors ‘of world renown.’

‘We expect a government-mandated restructuring at some point over the next 12 months,’ said Damien Horth, a Hong Kong-based analyst with UBS.

Early this year, Air China sought a tie up with China Eastern, whose executives rejected the offer, citing a lack of international management expertise.