Is the Impact of China and India on Future Long-Haul Travel Exaggerated?

July 2006 BCG FOCUS Is the Impact of China and India on Future Long-Haul Travel Exaggerated? Meeting the New Challenges of the Airline Industry T his report is the second in a series on the airline industry produced by The Boston Consulting Group s travel and tourism practice. Other topics include understanding the demand for air travel, the rise of Middle Eastern carriers, and the role of the megahub in future airline traffic flows. The projected growth of China and India is sending shock waves through many of the world s major industries. Indeed, the rise of those two countries as sources of consumer demand and lowcost production is expected to transform sectors as diverse as mining, auto manufacturing, insurance, and information technology. Many observers assume that the airline industry will be one of those sectors. However, analysis conducted by The Boston Consulting Group on the likely impact of China and India on long-haul air travel from the perspective of both supply and demand has found otherwise. In fact, the effect of these countries economies will not be as strong for airlines as it will for other industries. Moreover, for airline managers in developed countries, the most exciting growth opportunities in long-haul travel in the short to medium term may lie much closer to home. A Demand Perspective No one doubts the importance of China and India in shaping the world s future economic landscape. Although many rapidly developing economies particularly those in Eastern Europe are projected to achieve GDP growth rates similar to those of China and India, only China and India have the one-billion-plus populations needed to translate this relative growth into pools of absolute new demand that rival those of the largest developed economies. Many industry observers assume that the same dynamic will be at work when it comes to air travel. Yet the link between GDP growth and underlying demand for air travel is more complex than forecasters assume. When it comes to long-haul travel, our analysis of the drivers of demand reveals an S curve relationship between demand and GDP per

capita. 1 (See Exhibit 1.) This relationship suggests that it is only when levels of GDP per capita reach approximately U.S.$15,000 per year that the full impact of economic growth starts to be reflected in commensurate rates of growth in demand for longhaul travel. Put another way, a 1 percent increase in GDP per capita has an impact of less than 1 percent on demand for longhaul travel when it occurs in countries with a GDP per capita below U.S.$15,000, and it has an impact of more than 1 percent on demand when it occurs in countries with a GDP per capita above U.S.$15,000. Therefore, China and India, with very low levels of GDP per capita U.S.$1,200 and U.S.$600, respectively have a way to go before their GDP-per-capita growth will translate into commensurate increases in demand for long-haul travel. (See Exhibit 2.) Even with highly optimistic assumptions about the future appreciation of exchange rates, it is hard to see China reaching the U.S.$15,000 inflection point before 2030, and India before 2040. Indeed, it is only after 2050 that China can hope to approach the United States in terms of absolute demand for long-haul travel. We do not mean to suggest that international airline managers should ignore China and India when developing their growth and network strategies. The key cities in both countries are clearly growing in importance as destinations in the networks of many carriers. And as Exhibit 2 indicates, China and India will eventually represent significant proportions of international long-haul travel. Moreover, some provinces, states, and cities will reach higher income thresholds 1. See the first report in this series, Understanding the Demand for Air Travel: How to Compete More Effectively, BCG Focus, June 2006. EXHIBIT 1 UNDERLYING DEMAND FOR LONG-HAUL TRAVEL DEPENDS ON GDP Population size = 100 million Long-haul outbound trips per 1,000 people 500 Long-haul outbound trips versus GDP per capita, 2003 400 Israel 300 United Kingdom 200 100 0 India China Colombia Venezuela Argentina Brazil Australia Switzerland Austria Sweden France Netherlands Germany Belgium Ireland Hong Kong United States South Korea Japan Spain Italy Taiwan GDP per capita (U.S.$) 1 Thailand 100 1,000 10,000 100,000 SOURCES: Travel Industry Association of America; Global Insight; U.S. Office of Travel and Tourism Industries (long-haul outbound trips by country); Datastream (GDP and population); BCG analysis. 1 The horizontal axis is on a logarithmic scale. 2 BCG FOCUS

EXHIBIT 2 IT WILL TAKE YEARS BEFORE GDP GROWTH TRANSLATES INTO INCREASES IN DEMAND FOR LONG-HAUL TRAVEL IN CHINA AND INDIA Long-haul outbound trips (millions) 600 Projection of underlying demand, 2004 2050 Total 500 Other 400 300 India 200 China 100 United States 0 2004 2008 2012 2016 2020 2024 2028 2032 2036 2040 2044 2048 SOURCES: Datastream; Goldman Sachs (Global Economics Paper No. 99, Dreaming with BRICS: The Path to 2050, October 1, 2003); BCG analysis. earlier than others. 2 Furthermore, airline strategists should take into account the possibility that Chinese and Indian airports might become viable alternative hubs for long-haul flying and that attractive domestic and shorthaul flying opportunities may arise in China and India. 3 A Supply Perspective If the demand-side implications of China and India are less impressive for the long-haul-airline industry than for other industries, what about the supplyside implications? For companies in airport construction, airport management, and the delivery of other aviation services, China and India present a large collective opportunity. The sheer volume of air traffic that will accrue through domestic and international flying in the two countries will necessitate considerable investments in infrastructure. In addition, China and India can offer effective low-cost alternatives for specific parts of the airline value chain. For example, substantial world-class maintenance operations are already established in China, offering, in some cases, more than 20 percent cost savings to carriers from developed countries. Likewise, many airlines have begun moving some customerservice activities to India. And, looking to the future, it is almost inevitable that production of commercial passenger aircraft or of major components will happen on a significant scale in China within the next decade or two. Although these developments in specific parts of the value chain will affect the supply side and cost base of the entire airline industry over time, we do not 2. Although some cities such as Shanghai and Mumbai will hit the U.S.$15,000 threshold earlier than less developed cities in the same country, it does not mean that the country s overall progression along the S curve will be any different from that of countries that have gone before it. In addition, the absolute size of the middle class and the wealthier cities may be greater in China and India than in other rapidly developing economies, but their size in relation to the rest of the country is not noticeably different. 3. See the upcoming BCG Focus on the role of the megahub in future airline traffic flows. Is the Impact of China and India on Future Long-Haul Travel Exaggerated? 3

think they will greatly alter the basis for competitive advantage in the industry. For that to happen, a specifically Chinese or Indian low-cost or high-service production model would need to emerge that could be exported to the rest of the world. There are two reasons why this scenario is unlikely to occur. Operating costs Cost of capital First, Chinese and Indian longhaul carriers do not have particularly low cost bases. In fact, we estimate that at least four major flag carriers in neighboring countries have lower unit costs than the typical Chinese or Indian flag carrier. 4 (See Exhibit 3.) Likewise, no Chinese or Indian carrier today has a product or service position that challenges the most successful Western carriers. Second, even if a Chinese or Indian carrier were to emerge with a significant and sustainable lower-cost or higher-service EXHIBIT 3 CHINESE AND INDIAN LONG-HAUL CARRIERS HAVE HIGHER COSTS THAN SOME NEIGHBORING COUNTRIES FLAG CARRIERS Estimated relative unit-cost position for a 7,000-kilometer flight 1 position than other international carriers, it wouldn t pose much of a threat. 5 Because competition in the airline industry is largely limited to carriers from countries at either end of a route, China or India would have an advantage only over those airlines that had that country as a departure or arrival point or on those routes to which that country s carriers had gained access through fifth (or higher) freedom rights. Once again, we are not suggesting that airlines do not have to think seriously about their costs and production arrangements in light of eventual Chinese and Indian developments. Stealing a march on competitors by outsourcing and offshoring costs to these countries, for instance, will often be a compelling strategic proposition. Furthermore, any airline that flies or is planning to fly to China or India should recognize that local airlines have the potential to become formidable competitors in terms of both costs and the products they offer. Compared with their counterparts in many other industries, however, long-haul-airline managers do not need to devote the same amount of consideration to the threat of Chinese and Indian production models. The Rise of the United States and Europe Typical Chinese / Indian flag carrier SOURCE: BCG analysis. Carrier A Carrier B Carrier C Carrier D Carrier E Other major Asian flag carriers 1 Unit costs equal total costs per available seat-kilometer flown. For Western airlines, the Holy Grail of long-haul demand may 4. See the upcoming BCG Focus on the rise of Middle Eastern carriers. 5. Although airlines find it difficult to create significant sustainable advantage in products and services, we believe that Chinese and Indian carriers have the potential to do so for their outbound residents (and possibly for inbound travelers from the diaspora). 4 BCG FOCUS

lie closer to home than either China or India. To demonstrate this, we need to return briefly to Exhibit 1 and look at demand from the higher end of the S curve. On the rising side of the S, growth in GDP per capita has a disproportionately larger impact on demand for outbound longhaul travel. Now consider Exhibit 4, which demonstrates the impact of the S curve relationship on various countries relative positions when it comes to projected growth in GDP and projected growth in long-haul demand over the next decade. Although projected GDP growth rates may be much lower for mature economies such as Western Europe, Japan, and the United States than for China and India, the gap between the developed economies and China and India when it comes to growth in demand for air travel is projected to be much narrower. Furthermore, the outlook for absolute growth in demand for long-haul travel shows that Western Europe, Japan, and the United States have greater prospects than China and India. The implications of this reversal in prospects are significant for managers of airlines serving developed economies. The potential for growth in supposedly mature markets may be much greater than people realize. The trick for airline managers will be working out how to tap into and realize this potential. Much of the growth will come from additional discretionary leisure flights, as already affluent populations find themselves with more disposable income and (especially for those in retire- EXHIBIT 4 WHEN IT COMES TO DEMAND FOR LONG-HAUL TRAVEL, WESTERN EUROPE, JAPAN, AND THE UNITED STATES HAVE GREATER GROWTH PROSPECTS THAN CHINA AND INDIA CAGR (%) CAGR (%) 12 10 12 10 8 6 4 2 0 8 6 4 2 0 Belarus Turkmenistan Japan India France Projected GDP growth, 2004 2015 Projected growth in long-haul travel, 2004 2015 20% of United States Taiwan Estonia Canada China South Korea United Kingdom Germany Japan SOURCES: Datastream; BCG modeling. 20% of United States Georgia India China Eastern Europe South Korea United Kingdom Germany France Western Europe 1,000 2,000 3,000 4,000 5,000 Western Europe United States Absolute change (U.S.$billions) United States 5 10 15 20 25 Absolute change in outbound residents (millions) Average Average Is the Impact of China and India on Future Long-Haul Travel Exaggerated? 5

ment) increasing amounts of leisure time. Significantly, lower prices the mainstay of the short-haul, lowcost-carrier revolution will be only one lever for stimulating this extra demand. Airline managers need to go beyond current ways of thinking about stimulation and concentrate on other, less familiar levers to unlock these new sources of demand. We believe it will be critical for airlines to spend more time trying to understand their customers. Airlines will need to go beyond simply analyzing the flying patterns and in-flight product preferences of their current customer categories. They will have to delve into each key potential segment s desires, needs, and fears. Airline managers will have to know what factors drive their customers decisions across various discretionary purchasing categories, how customers make tradeoffs, how they are (or can be) influenced, and how these elements vary among customer segments. In short, airlines will have to think and act more like successful consumer companies the Apples and Starbuckses of this world if they hope to seize the untapped potential of developed markets. A Checklist for Getting Started All long-haul-airline managers need to have China and India on their radar. Neither country can be ignored as a destination, potential competitor, demand opportunity, or source of potential offshore-based savings. However, the significance of China and India will be less of a concern in the airline industry than in many other industries, and longhaul-airline managers must ensure that exaggerated expectations about demand growth in those two countries do not blind them to the possibilities of growth in more developed markets. To determine whether their expectations for China and India are realistic, managers should ask themselves the following questions: Have we rigorously tested the assumptions both implicit and explicit behind our forecasts for activity between our home country and China and India? Are our assumptions based on simple GDP rules of thumb or on a more in-depth understanding of the relationships among fundamental demand drivers, such as GDP per capita? Have we tested the potential for further growth in our home market and in other developed markets? Do we understand why some countries have much higher per capita demand for long-haul air travel than others? Do we think about our future customer base in terms of the flying patterns of our current passengers or in terms of the needs and attitudes of all key customer segments in society? Have we got a good picture of how baby boomers (and other key segments) intend to use their leisure time and disposable income? Do we view our competitors as other airlines or as other contenders for consumers disposable income? Can we achieve significant cost savings by moving some of our operations offshore? If so, what is the strategic impact of not doing so? Do we have a full understanding of our current and future China- or India-based competitors? What are our sources of competitive advantage when it comes to these carriers? Can we sustain these advantages? Airlines that get the balance right should be rewarded with improved growth prospects in developed markets and a seat at the table in the markets of the future. 6 BCG FOCUS

Is the Impact of China and India on Future Long-Haul Travel Exaggerated? 7

Since its founding in 1963, The Boston Consulting Group has focused on helping clients achieve competitive advantage. Our firm believes that best practices or benchmarks are rarely enough to create lasting value and that positive change requires new insight into economics and markets and the organizational capabilities to chart and deliver on winning strategies. We consider every assignment to be a unique set of opportunities and constraints for which no standard solution will be adequate. BCG has 61 offices in 36 countries and serves companies in all industries and markets. For further information, please visit our Web site at www.bcg.com. About the Authors Ross Love is a vice president and director in the Sydney office of The Boston Consulting Group and global leader of the firm s travel and tourism practice. James Goth is a manager, Frank Budde a project leader, Dale Schilling a consultant, and Ben Woffenden an associate in the Sydney office. For Further Contact This series of reports on the new challenges facing the airline industry is sponsored by The Boston Consulting Group s worldwide Consumer practice. For inquiries about this report or others in the series, please contact Ross Love at love.ross@bcg.com or James Goth at goth.james@bcg.com. You may also contact Martin Koehler, senior vice president and director in BCG s Munich office, at koehler.martin@bcg.com; or Alan Wise, vice president and director in the firm s Atlanta office, at wise.alan@bcg.com. To receive future publications in electronic form about this topic or others, please visit our subscription Web site at www.bcg.com/subscribe. Acknowledgments The authors wish to acknowledge the valuable contributions of their colleagues Katherine Andrews, Harry Bailey, Sally Seymour, Marita Shevland, and Sharon Slodki. Amsterdam Athens Atlanta Auckland Bangkok Barcelona Beijing Berlin Boston Brussels Budapest Buenos Aires Chicago Cologne Copenhagen Dallas Detroit Düsseldorf Frankfurt Hamburg Helsinki Hong Kong Houston Jakarta Kuala Lumpur Lisbon London Los Angeles Madrid Melbourne Mexico City Miami Milan Monterrey Moscow Mumbai Munich Nagoya New Delhi New Jersey New York Oslo Paris Prague Rome San Francisco Santiago São Paulo Seoul Shanghai Singapore Stockholm Stuttgart Sydney Taipei Tokyo Toronto Vienna Warsaw Washington Zürich BCG www.bcg.com The Boston Consulting Group, Inc. 2006. All rights reserved. Rev. 12/06