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China has enjoyed double digit growth in air passenger and air freight over the past several years, and all predictions are for continued robust growth in demand, driven in part by China's accession to the World Trade Organization (WTO) and the remarkable increase in internal tourism in China. The challenge for China will be to meet this explosive demand with new and expanded airports and aviation infrastructure.

Chinese domestic airlines carried 87.59 million passengers last year despite the adverse impacts of SARS. January and February 2004 saw the rise of about 20% in all performance measurements compared with the same period in 2003. CAAC officials have reported that in April 2004 that the total cargo traffic for this year will be 20 billion ton kilometers--17% more than that of last year, passenger traffic is projected to reach 103.8 million--an increase of 19%, projected cargo and mail volume will be 2.5 million tons for a growth of 14%. The CAAC also forecasts an average annual growth rate of 10% for the five years from 2006 to 2010.

Recognizing this enormous challenge, and the difficulty of meeting it with the historical approach, China's government has undertaken a major restructuring of the airports and aviation sector.

An initial step was the authorization in July 2000 of the reorganization of ten airlines under the direct control of the General Administration of Aviation of China (still usually known by its old initials, "CAAC") into three air transportation groups: Air China, China Eastern and China Southern Group. This step indicates the sense that the old approach is not likely to meet China's tremendous demands for new air transportation capabilities.

A further restructuring step was the January 2002 decision by the State Council (the highest administrative authority in China) to transfer responsibility for operation, development and financing of airports from the national level to local governments. This is discussed in more detail below.

A most significant additional element of the restructuring is a regulation designed to give foreign operators and investors wider access to China's fast-growing aviation market in accordance with China's commitments upon accession to the WTO. The government of China recognizes that the international resources (both in capital and in airports and aviation expertise) are vital to meeting the accelerating demand for air transportation services to and from, and most of all, within, China.

Finally, China and the US in late June 2004 agreed to liberalize substantially passenger air carrier and air freight services between the two countries, including allowing additional carriers, flights to more cities in each country, and establishment of cargo hubs within each country, as well as broader code-sharing arrangements.

The Airport and Aviation Investment Regulation

The Regulation on Foreign Investment in Civil Aviation Industry was issued on June 21, 2002 by the CAAC, the Ministry of Foreign Trade and Economic Cooperation (now known as the Ministry of Commerce, or "MOFCOM") and the State Development and Planning Committee (now known as the National Development and Reform Commission, or "NDRC"). The 2002 regulation supersedes a related 1994 CAAC Notice, and increases dramatically the potential for foreign participation in the ownership, development and financing of China's airports and airlines.

Foreign investment in Chinese airlines is nothing new. American Aviation Ltd., a George Soros-invested fund, invested $25 million in 1995 for 25% stake (currently 14.8%) in Hainan Airlines, once called "The Best Little Airline in China" by the Far Eastern Economic Review. We have represented Hainan Airlines in connection with the establishment of an American Depository Receipts or ADR program.

The 2002 regulation allows larger share-holding percentage of foreign players who can "inject advanced management and mature business models" into Chinese partners (words of a CAAC vice-minister) and at the same time share the fast development of one of the world's biggest aviation markets.

The highlights of the 2002 regulation regarding civil airports (Category One) are:

• Foreign investors can invest in two types of civil airport projects: (i) airside projects, such as runway, taxiway, apron airfield aid lighting systems, and (ii) terminal projects, such as terminal construction.
• Chinese party has to hold "relative majority shares" in the joint venture. "Relative majority shares" means that the shareholding percentage of the Chinese party has to be greater than any of its foreign partner(s).
• In a foreign-invested airport, fees for its aeronautical services and facilities will be set by the central government, but its non-aeronautical fees can be set by the airport at its discretion as long as those fees are confirmed by the local pricing bureau.
• A foreign investor who invests in civil airports will receive priority in investment opportunities in other "aviation-related projects" (see Category Three below).

Regarding investments in domestic airlines (Category Two):

• Foreign investment by any one foreign investor (including its affiliates) caps at 25% in an airline engaged in public transportation with total foreign investment caps at 49%, which is an increase from the 35% limit under the 1994 CAAC Notice.
• Chinese investors should hold majority shares in airlines engaged in governmental, industrial and sightseeing services, while for agricultural, forestry and fishing services, foreign investors are allowed to hold majority shares.
• Any foreign investor investing as a cooperative joint venture partner in airlines engaged in public transportation, governmental or sightseeing services has to be a Chinese legal entity, in other words, through an entity established in China.

As for investments in aviation-related projects (Category Three):

• The 49% share-holding limitation on aviation oil supply and aircraft maintenance services is still in existence, while no such limitation exists on cargo storage, ground services, food catering and parking lots.

For all three categories of investment:

• Foreign investment in aviation projects can take the following forms: forming Sino-foreign joint ventures, stock purchases, or other approved investment methods. In a press conference following the issuance of the 2002 regulation, the Director General of the Policy and Regulatory Department of CAAC commented that "other approved investment methods" will include BOT.
• No joint ventures can operate for exceeding 30 years.
• Foreign investment and/or management is not allowed in air traffic control systems.
• It is important to note that the regulation does not require the chairmen of the boards of directors or managers of the companies or airlines with foreign investment to be Chinese.

Transfer of Airports to Local Governments

In accordance with the Civil Aviation Reorganization Plan adopted by the State Council on January 23, 2002, one hundred and twenty-nine (129) civil airports directly managed by the CAAC are being transferred to local governments, with the exception of the Beijing Capital International Airport, Guangzhou Baiyun International Airport and the civil airports in Tibet. At the end of last year, the transfer in a few provinces has been already completed.

With localized administration of the airports, the local governments are facing the daunting prospect of financing the development and maintenance of the airports, which provide vast opportunities for private and foreign participation.

China--US Air Services Agreement

In late June, China and the US reached a landmark air services agreement between that will more than double the number of U.S. airlines that may serve China and will permit a nearly five-fold increase in weekly flights between the two countries over the next six years. The agreement will also substantially increase the "doing business" freedoms of U.S. carriers in China, including the right for U.S. cargo airlines to establish hubs in China. The agreement was reached in Washington, D.C. after four rounds of talks starting last February.

Even as U.S.-China aviation services have remained limited, trade between the two countries has grown dramatically, increasing in value from $4.8 billion in 1980 to $170 billion in 2003. The United States is China's largest export destination, and China is the United States' fastest-growing export market.

The last agreement to expand U.S.-China air services was concluded in April 1999, when each country's carriers were allowed to increase their weekly flights in the market from 27 to 54, and each side was allowed to designate one additional airline --- for a total of four --- to serve the market.

This agreement will allow five additional airlines from each country to serve the U.S.-China market. The United States may name one additional all-cargo airline, while China may name either a passenger or cargo airline, to start service later this year. The other four new-entrant airlines may be either passenger or cargo carriers, with one new carrier entering the market in each of the years 2005, 2006, 2008 and 2010. United Airlines, Northwest Airlines, Federal Express and United Parcel Service currently serve China.

The two countries also agreed to allow each country's carriers to serve any city in the other country. Currently, Chinese carriers are limited to 12 U.S. cities, and U.S. passenger carriers may fly to only five Chinese cities. The agreement also will permit unlimited code-sharing between U.S. and Chinese airlines, thus expanding on the current agreement, which allows code-sharing only to a limited number of cities.

The agreement also provides that when carriers establish cargo hubs in the other country, they will be afforded a high degree of operating flexibility, and expands charter opportunities beyond those provided by the existing agreement.

The two sides will resume talks in 2006 to review the aviation relationship and make further progress on liberalizing the agreement.

Opportunities: Airports, Airlines, Air Cargo Service and Air Traffic Control

Shortly after the release of the 2002 regulation, Zane Gresham, co-head of Morrison & Foerster LLP's Global Airports and Aviation Group, was invited by CAAC to come to China to lecture on methods of financing airports and aviation infrastructure at a major meeting of CAAC officials, airport managers and local government officials. Again, in April 2004, Mr. Gresham was invited by CAAC and the US Trade and Development Administration as a speaker on "Olympics and Other Major Events' Challenges for Airports" at the 3rd China-US Aviation Symposium held in Beijing. Based upon Mr. Gresham's personal meetings with senior CAAC officials and other international experts attending these conferences, we believe that China's aviation market presents significant investment opportunities for foreign investors, especially in the southwestern area.

According to official CAAC data, from 1980 to the end of 2003, the total amount of foreign capital flowing into the Chinese civil aviation sector was US$32.513 billion. However, most of that foreign capital was in form of loans, such as government loans and financial leasing, while investment including direct foreign investment or overseas listing of China airports and aviation enterprises represents only a small portion.

Airports.

As mentioned above, local governments are very likely to face difficulties in financing the airports which now have been placed under their administration and financial responsibility. This is likely to be most acute for local governments and airports in the western region, which also is targeted by the national government substantial economic growth. The State Council has granted a series of preferential treatments (such as tax breaks, flexible financing methods and expedited approval processes) to investments in the western region, such as Guangxi, Inner Mongolia, Tibet and Xinjiang. The State Council, the CAAC and the local governments may offer even more beneficial treatments in the aviation sector beyond those already provided in the 2002 regulation.

In light of the rapid growth in demand, and the legal and financial restructuring, we expect that China's airports and aviation sector will have to rely on new financing methods, such as bonds and project financing. A number of analysts have observed that the potential for an internal China bond market is growing, driven in part by the relatively high savings rate in China, and in part by the need of the nascent insurance industry for investment instruments to match long-term insurance obligations with long-term investments.

The airports at the local level have been structured in a number of ways: departments of municipalities, special aviation authorities or other local government entities. It is worth noting, however, that a significant number of these airports have taken advantage of the limited liability company or company limited by shares organizational structure. Shanghai Airport and Kunming Airport are examples of major airports now operated by companies incorporating private shareholders. Beijing Capital International Airport which is under the national administration is also operated by a company listed in Hong Kong and of which Aeroports De Paris Group holds nearly 10% stake.

Foreign companies have been allowed to bid for the design, consultation, surveillance and management, or construction of civil airport projects. Foreign companies have been involved in design projects for terminals of several airports, such as Beijing Capital International Airport, Shanghai Hongqiao and Pudong Airports and Guangzhou New Baiyun International Airport.

The 2002 regulation also provides China's airports with greater flexibility to involve private airport operators and airport service companies. This will affect overall airport operations, as well as specific areas such as concessions, cargo and ground handling.

Airlines.

From an international perspective, the most substantial opportunities will be created by the China--US air services agreement that was reached in late June 2004. This will open up cities in China and the US for direct service by carriers from the other country, and allow for more robust code-sharing and joint venture activities.

On the domestic front, the willingness of China to accommodate new air carriers is reflected in the recent CAAC approval of the establishment of two private airline companies, to be based in Shanghai and Tianjin.

Investors of the two companies must complete preparatory work in two years, including required aircraft flight and maintenance certification. The planned airline in Shanghai, a joint venture of the Shanghai Spring International Travel Service Ltd. and Shanghai Spring Charter Flight Travel Service Co., is to operate passenger and freight flights with Shanghai Hongqiao International Airport as its base. The planned airline in Tianjin, a joint venture of Beijing Qili Logistics Co. and two other companies, is to use Tianjin Binhai International Airport as its base for passenger and freight flights, and ground distribution and storage.

The administration has so far given the go-ahead to the establishment of three private airline companies. Preparations for establishing a private airline company in Chengdu, southwest China's Sichuan Province, received approval from the administration in February.

Air Cargo.

Domestic and overseas cargo airlines will be allowed set up ventures in China as China further loosens its control over the air cargo market. This has been evident from international agreements (the China-US air services agreement referred to above), and internal regulatory changes.

On the internal side, Li Yongqi, deputy director of Planning and Financial Development for the CAAC told participants at the China Air Cargo Summit 2004, that restrictions on imports of cargo aircraft will be relaxed. CAAC intends that approval procedures for purchasing aircraft be simplified and rules to approve cargo air routes and flights be reformed.

To date, CAAC has received applications from US FedEx Express for setting up a solely funded cargo base in Guangzhou, besides, Shenzhen Airlines has also applied to establish a JV cargo airline with Lufthansa Cargo.

In the past few years, CAAC has taken a series of measures to stimulate the nation's air cargo business. In addition to Shanghai's bid to turn Pudong Airport into an air hub, CAAC has indicated it will give priority to the airports in Tianjin, Guangzhou, Shenzhen, Wuhan and Kunming to create cargo hubs.

Air Traffic Control.

The continuing growth of the aviation sector makes it clear that China will have to vastly improve its air traffic control system, which currently is operated on a semi-autonomous basis in different regions. This will present opportunities for companies that provide navigational aids and air traffic control equipment and services, even though foreign investment and/or management is not allowed in air traffic control systems under the existing regulation.

Conclusion

The State Council, NDRC, MOFCOM and CAAC all have recognized the need for a major restructuring of the airports and aviation sector, and the need for foreign capital and know-how, if China is to have any chance of meeting the burgeoning demand for air transportation that both reflects, and will support, the economic growth. The growth in the airports and aviation sector is also being propelled by the increasing demand for air services in China in light of the 2008 Olympics in Beijing and the 2010 World Exhibition in Shanghai.

More importantly, the government has taken real action to implement major reforms. These changes will create opportunities for airport operators, financial institutions, air cargo and logistics companies, aviation and airport equipment suppliers, and, indeed, many other businesses.

To participate in this process will require a bit of patience and a dose of creativity, as the rules are still being written, and textbook solutions from other countries are not likely to transplant easily.

Ultimately, however, the growth potential in the market should be rewarding for the persistent and thoughtful who take the time to understand and respond to China's evident need for improved airport and aviation infrastructure and facilities.