No. 21 — May 26, 2000

Feature Article

JAPAN'S AVIATION INDUSTRY: DEREGULATION ADVANCES ON BROAD FRONT

Arthur J. Alexander

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Summary

Since the mid-1980s, deregulation has moved Japan's aviation business unevenly but persistently toward a more open, competitive market structure. The process was given a sharp nudge forward in late 1998 when two new domestic carriers started service. It received another boost February 1, 2000 with the almost complete liberalization of fares and routes.

The remaining hurdle to achieving "open skies" in the domestic market is the shortage of takeoff and landing slots at Japan's two busiest airports — Tokyo's Haneda and Osaka's Itami, which together handle three-quarters of all in-country passengers. At the same time, the limited availability of takeoff and landing slots at Tokyo's Narita International Airport, the principal overseas gateway, is holding up further liberalization of foreign flights. With new runways at both of Tokyo's airports planned for completion within the next two years, many of the remaining barriers to a liberalized aviation environment in Japan soon will be eliminated. Still to be accomplished, however, is the thorough restructuring of the country's major carriers, which will entail reducing costs and otherwise improving finances in order to increase profitability.

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Rigid Structure Based On Postwar Law And Regulation

The basic framework for Japan's aviation industry was established by the Civil Aeronautics Law of 1952, which gave the Ministry of Transport the mandate to set routes and fares and approve operators. Japan Airlines Co., Ltd. had been formed the year before. In 1953, the government became the airline's controlling owner by putting up half of its capital. JAL entered the international air transport market in 1954 as Japan's "flag carrier" — the term used at that time to denote a country's designated international airline. While JAL had a monopoly on overseas routes, several companies competed in the small and chaotic domestic market of the early postwar period. Two of them merged in 1957 to form All Nippon Airways Co., Ltd.

The industry was brought under the heavy regulatory hand of MOT with the adoption in 1970 of a cabinet resolution, Concerning Airline Operations, which was implemented in 1972. The so-called 1970-72 system, also referred to as the "aviation constitution," created a segmented industrial structure built around three companies: JAL, ANA and Toa Domestic Airline Co., Ltd., the latter formed under official direction through the merger of two smaller carriers.

Under the 1970-72 system, JAL had responsibility for international service and a few domestic trunk routes — that is, routes connecting Tokyo, Osaka, Sapporo and Fukuoka. ANA was given domestic trunk routes, local routes and some short-haul international charter flights. TDA, which merged with several other small carriers to form Japan Air System Co., Ltd. in the 1980s, received local routes and a portion of the domestic trunks. Competition among the three carriers was almost nonexistent.

Near-monopolies on most routes as well as regulated fares allowed MOT to assign unprofitable flights serving outlying islands or small towns to ANA and JAS. The earnings from high-density routes subsidized this far-flung network, parts of which had been established under pressure from influential Diet members looking after their constituents' interests.

The 1970-72 system was internally consistent. It allowed the three airlines to earn sufficient profits to maintain service to important domestic and international centers. It also provided the cross-subsidization to satisfy other locales. The absence of competition on prices and routes or from the entry of new carriers guaranteed a relatively quiet life for JAL, ANA and JAS. It also brought high fares and costs that grew increasingly out of line with those of deregulated airlines in the United States and elsewhere. However, forces were brewing on the international front and in aircraft technology that would cause the unraveling of the 1970-72 system.

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Competition Stirs Up Domestic And International Markets

Following the late 1970s' deregulation of airline operations in the United States, the White House turned its attention to the international system's cartelized market structure and government price supports. In negotiations over bilateral pacts, the mechanism that governs international aviation relations among most countries, Washington sought more liberal entry and pricing arrangements. Its eventual aim was deregulated international "open skies." Japan was an early target of American negotiators because its 6 percent share of total U.S. international passenger traffic seemed small in comparison with the potential market that could be accessed if fares and routes were liberalized.

Japan's aviation policymakers recognized in the early 1980s that the deregulatory wave ultimately would break over their own shores. They hoped to introduce such reforms as might be desirable and necessary at a pace that would allow domestic participants time to adjust to the new economic forces and regulatory regimes. Implementation was expected to last decades.

Before this policy could be articulated very clearly, however, a sharp increase in the demand for international cargo flights and the introduction of Boeing Co.'s wide-body 747 aircraft made lower-cost freight traffic technically and economically feasible. MOT opened a small crack in Japan's segmented market structure in 1983 when it granted a license to Nippon Cargo Airlines Co., Ltd., a venture formed by ANA and six major Japanese shipping companies. The appearance of NCA as a competitor to JAL on international cargo routes was the first challenge to the 1970-72 system.

The crack widened further in 1985 when the United States and Japan began a new round of negotiations over transpacific rights. The agreement that emerged was based on the principle of "balanced expansion." It allowed three new carriers from each country to launch service across the Pacific. To forgo this opportunity would have left Japan faced with a dominant American presence in the all-important U.S.-Japan market. Moreover, by this time, Japan had signed aviation agreements with Australia, France, Great Britain and other countries that also allowed more than one Japanese carrier to serve those markets.

The logic of the 1970-72 system made it impractical for Tokyo to open the international market to new entrants and still keep the domestic market tightly regulated. JAL would face stepped-up competition and probably declining revenues and profits without the opportunity to make up the difference elsewhere. Moreover, ANA was losing money on some 70 percent of its domestic flights. New competition on its major, profitable routes would jeopardize the carrier's financial survival.

Unsure of how to handle the potential problem of new Japanese airlines flying international routes, MOT turned to one of its advisory committees. That blue-ribbon panel recommended increased competition in both the international and the domestic market. The suggested framework allowed for multiple carriers on international routes, new entrants on routes serving domestic city pairs (as warranted by traffic volume) and the privatization of JAL. With these recommendations and the earlier creation of NCA, the 1970-72 system was swept away by the wave of deregulation that MOT had forecast. It happened, however, years before aviation policy planners had anticipated. The advisory committee advocated the introduction of "double and triple tracking" — the practice of two or three carriers servicing a particular route — based on passenger volume. MOT implemented this suggestion by declaring that two airlines would be allowed on routes with at least 700,000 passengers a year and three carriers would service routes with more than 1 million passengers annually. For the first time, JAL, ANA and JAS faced competition on their most important routes. In return, however, they were permitted into market segments that had been off-limits.

In its measured way of promoting a more competitive industry, MOT lowered the hurdles for double and triple tracking in 1992 to 400,000 and 700,000 passengers a year, respectively. In 1996, they were cut further to 200,000 and 350,000.1

ANA took advantage of the new opportunities. By 1990, it controlled 10 percent of Japan's international passenger traffic, doubling that share to 20 percent in 1997.2 JAL did the same in the domestic market, competing with ANA on routes between the densest city pairs and quickly capturing 20 percent of in-country traffic. Its cut of the domestic passenger business hovered at a bit less than 25 percent over the next 15 years. Meanwhile, ANA's domestic share, which had been around 60 percent before the breakdown of the segmented system, fell to around 45 percent. JAS and a handful of small local carriers shared the remaining third-plus of Japanese traffic.

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MOT Policies Create Barriers To Expansion

The market shares of JAL and ANA quickly plateaued in their new operations because of capacity constraints at Japan's major airports. Although both airlines were willing to add flights on existing routes and to inaugurate new ones, the takeoff and landing rights that they needed to do so could only be obtained by taking them from some other carrier. Thus, the expansion plans of the airlines were strangled and the Transport Ministry's deregulation hands tied.

In fact, though, the shortage of slots was partly the result of the ministry's own policies. MOT's airport construction efforts had been directed at building new airports rather than expanding established facilities in major markets. Pork-barrel politics and the clout of Japan's construction industry were behind this approach.

Every district wanted an airport or a construction contract, and MOT, at the urging of the political leadership, obliged. As a result, many of the regional airports built were underused while others were bumping against capacity ceilings. Furthermore, high usage fees were imposed in addition to steep landing and other charges to raise money to pay for the construction of the new facilities. Landing fees at Narita International Airport, for example, are more than three times those at New York's J.F. Kennedy International Airport and almost five times higher than the surcharges at London's Heathrow International Airport.3

In 1998, MOT finally shifted gears, instituting a new focus on improvements at major hubs. A ministry spokesman, citing Japan's continued economic slump, reported that an outright ban on new airports was under consideration. Those comments were interpreted as a message to local politicians and officials that the old days were over. However, the ruling Liberal Democratic Party has not yet stopped construction companies from pouring more concrete on local runways.

Money diverted from airport building projects was to be earmarked to offset reduced landing fees at local airports.4 One reason for using the savings this way was that steep airport charges were leading airlines to shift flights to more lucrative cities and to abandon lower-density routes. Small airports were not the only ones affected by high fees. By early 1999, five foreign carriers had suspended operations at Osaka's Kansai International Airport. On paper, the September 1994 opening of this engineering marvel, which enabled Japanese and foreign airlines alike to better serve Japan's second-largest city and the surrounding area, went a long way toward resolving the capacity constraint, at least in this populous region. However, in an attempt to recoup part of the huge costs of building the facility, KIA authorities imposed stiff — and, ultimately, counterproductive — fees.

Another enduring problem is that what capacity exists is not used efficiently because of the power of the air traffic controllers' union over operating procedures. In the mid-1980s, most airports were open less than 13 hours a day. Just three airports operated round the clock. Osaka's Itami Airport operated 13 hours daily but with many restrictions, while Haneda Airport outside Tokyo was open 17 hours. Local jurisdictions attempting to control noise imposed many of these restrictions, but they were abetted by the controllers' union.

Historically, the Transport Ministry has seemed to be unwilling to confront the union's objections to longer hours and increased flight frequencies. For example, in 1985, Narita International Airport had about 12 aircraft movements per hour.5 By 1999, the number had increased to roughly 26 per hour. One indication that the Narita constraints were artificially imposed in the earlier period is the sharp increase in flight numbers over those years. However, at the comparable one-runway airport at London's Gatwick Airport, the hourly rate is between 41 and 46 flights.6

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Revising The Fare Structure

In 1986, MOT had introduced a new fare structure based on a standard pricing formula. Published tariffs, which required ministry approval, were built on the notion of average costs plus a "reasonable" profit. Costs comprised both a fixed portion and a variable component based on distance. Fares for flights of a given length were supposed to be the same, regardless of the number of passengers or other factors that might influence costs or demand. A major reason for this approach was that politicians from smaller towns and from Hokkaido did not want their constituents disadvantaged by having to pay higher fares than people living in more populous areas.

According to the standard pricing formula, a one-way ticket for the 250-mile flight from Tokyo's Haneda to Osaka's Itami was ¥16,350 ($150 at ¥110=$1.00), based on a fixed portion of ¥9,500 ($90) and a variable part of ¥27.4 (25 cents) per mile. The calculated one-way fare for the 510-mile trip from Tokyo to Sapporo was ¥23,440 ($200). Actual fares were allowed to vary within 10 percent of the standard. Under the 1986 plan, airlines' published ticket prices were to remain within a few percent of the standard fares for the next 10 years.

Beneath this seemingly well-regulated surface, however, real competition was having a predictable effect. The introduction of multiple carriers on the most heavily traveled domestic routes coincided with the arrival of new wide-bodied aircraft designed for short to medium hauls. These planes could provide service at a lower cost — but only if they were filled with paying passengers.

Japanese airlines sought to sell seats by negotiating discounts with travel agents. Regulations allowed discounts from standard fares of up to 50 percent on group packages. Making use of these cut rates, travel agents were able to offer such attractive prices that customers could afford to discard hotel vouchers or any other parts of a deal that they did not need because the air portion alone was worth more than the total price of the package. Large travel agencies also sold excess capacity to smaller discount agencies, which, in turn, offered the group fares on an individual basis.

Taking a lesson from their American counterparts, Japanese airlines offered rebates to travel agencies that sold more than an agreed-on number of discounted seats. While the airfares included in the group tour packages fell within the guidelines set by MOT authorities, the rebated tickets and the individual discounted fares did not. The ministry, however, seemed unwilling to enforce its pricing regulations, possibly because Japan's Fair Trade Commission had become interested in cartel arrangements among the airlines.

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Rewriting International Aviation Agreements

Competition was beginning to rear its price-reducing head in the international arena as well. The 1952 U.S.-Japan air transport services agreement had been written at a time when domestic and international aviation markets were thoroughly regulated and cartelized. The pact included such concepts as control of capacity and required government approval for most changes. In the first half of the 1980s, U.S. aviation negotiators insisted repeatedly during bilateral talks that Washington could name any interested carrier to fly routes to Japan. The Japanese team responded that free entry went well beyond the original intent of the agreement, adding that any new entrants that might be designated should not have the full rights granted to the "incumbents" named in the 1952 document.

A memorandum of understanding that Washington and Tokyo concluded in the spring of 1985 created two classes of carriers on each side. One consisted of incumbents with relatively unrestricted rights to fly to designated gateway cities in the other country and beyond. The second group was made up of new entrants. Their operations were constrained by explicit agreements on beyond rights. Schedule approvals as well as slot constraints also limited business.

Intense domestic competitive pressures following the deregulation of the U.S. aviation market in the late 1970s had forced American carriers flying into Japan to lower their costs. Between 1978 and 1985, their average revenue per passenger mile on both domestic and international routes dropped 25 percent. As costs and fares fell and traffic expanded, U.S. airlines were able to take advantage of their ability to gather large numbers of passengers at domestic hubs and offer low fares on international routes. Japanese airlines were forced to meet these fares if they wanted to carry passengers overseas. Ticket prices on international routes generally are set by the lowest-cost company flying between two countries. These often are American, although Singapore Airlines and other carriers jockey for that position in Asia. As in the domestic case, Japanese airlines first competed through travel agents rather than by offering lower fares directly to passengers.

By 1993, the discrepancies between published tariffs and the international fares available through travel agents were so large that, according to industry consensus, some action was needed to bring the figures into alignment. An off-season, round-trip coach trip between Tokyo and Los Angeles, for instance, could be had for 80 percent off the published standard tariff. Several estimates made at the time indicated that, depending on the route and the season, as many as 50 percent to 80 percent of all travelers were paying less than the standard fares.7 When Tokyo introduced new international fare rules in April 1994, authorized discount fares for individuals fell by 60 percent, "nearing current market prices" in MOT's view.8

The fall 1994 opening of Kansai International Airport further undercut MOT's international pricing scheme. With the added capacity, ticket prices fell as much as 40 percent, MOT calculated. This fresh source of pricing pressure expanded the threat to the new system of international fares put in place only months earlier.9

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International Pricing Pressures Affect Domestic Market

With the advent of lower international fares, Japanese tourists were flocking to foreign locations rather than to more distant resorts at home. A golfing holiday in Guam or Hawaii, for example, could be a better deal than the same type of vacation on Okinawa. In January 1994, MOT announced that it would introduce legislation in the Diet to allow discounts of up to 50 percent on domestic fares for "strategic business reasons." Moreover, in an important break with past practice, the lower rates did not require explicit MOT approval; an airline simply needed to notify the ministry of its fares. The rules, implemented in December 1994, allowed carriers to respond more quickly and flexibly to competition.

The Transport Ministry could not, however, completely abandon its oversight role. Officials stated that the purpose of this round of deregulation was "to stimulate demand, not to get into a dumping war." They added that MOT would not accept a situation in which discounts resulted in a drop in total revenues. "If sales decline due to a particular discount, we may issue an administrative order to stop the discount."10

Standard fares quickly became the exception on both domestic and international flights as customers sought out discounts, either from the airlines themselves or from travel agencies that specialized in low-priced tickets. Figure 1 depicts the revenues per passenger-kilometer that ANA and JAL took in on domestic routes — in short, the actual amount of money collected by the two airlines, undisguised by regulation, formula or published list prices. Also shown are the average yields for American carriers on their domestic routes, converted into yen using the purchasing power parity for each year. The use of purchasing power parity instead of exchange rates makes it possible to present fares in terms of the relative costs and prices of both countries.

As early as 1986, the average fare collected by ANA was ¥22 (20 cents) per passenger-kilometer, which would have produced a Tokyo-Osaka ticket price of ¥8,866 ($80), or about half the standard price according to MOT's formula. Actual revenues fell in the early 1990s. By 1999, JAL's average price was around ¥15 (14 cents) per passenger-kilometer and ANA's about ¥2 (2 cents) higher. Such differences might be due to variations in route structures or to a carrier's ability to attract more business customers willing to pay for first-class seats. ANA, for example, flies more high-cost routes with fewer passengers and less competition. The other striking feature of Figure 1 is that the fares of Japan's two biggest carriers are nearing those of American airlines.

Figure 2 presents the same type of information for international yields. In this case, however, American revenues are converted into yen using exchange rates rather than purchasing power parity. Japanese carriers competing in international markets may earn dollars, but they have to convert those to yen based on actual exchange rates. Consequently, such a comparison shows the real competitive pressures confronting JAL and ANA. The remarkable development evident here is the convergence of Japanese and American prices. Although this fact does not necessarily reveal anything about relative efficiencies, it does underscore the vicious competition in the international aviation market.

With falling prices as a backdrop, MOT introduced in April 1996 a new fare structure based on the notion of standardized costs — just like all its pricing schemes since 1970. Published fares could be as much as 25 percent below the standard, which acted as a price cap. Even if a carrier reduced its standard fares by the maximum 25 percent, though, the results still would be considerably above the average fare actually collected. Nonetheless, this approach permitted discounts on a much broader and deeper scale, including time-of-day and time-of-year discounting, advance-purchase discounts and group discounts. Individuals who booked directly with airlines rather than through travel agents could receive discounts of up to 50 percent, but they also paid the maximum fares for travel during Golden Week (which extends from late April through early May) and at other peak times.

The Japanese media treated the new fares as price increases because the average standard fare rose by about 1 percent. Surprisingly, news accounts said little about the availability of discounts and mentioned nothing about the fact that actual fares typically were only about half the list prices. Even Japan's leading business newspaper, Nihon Keizai Shimbun, headlined the change and began its story with the assertion, "[r]ather than deflate prices, deregulation of airline ticket prices in Japan is sending sky-high fares even further aloft."11 A respected U.S. aviation magazine went along with this story, quoting the statement, "Japan has never had fare competition until now. ... Domestic ticket prices have not changed since 1982, a JAL official noted."12 What these perceptions had in common was confusion between list prices and transaction prices. According to industry experts, 30 percent to 50 percent of passengers were flying in 1996 at prices considerably below list, yet somehow this widespread practice escaped the media's notice.

Travel agents took note, however, since the new discount fares offered directly to individuals by airlines could be even lower than the group fares arranged by travel companies. Such a shift in pricing power obviously benefited JAL and ANA. By selling tickets directly to passengers, the airlines could avoid paying commissions. And, since at that time, 70 percent to 80 percent of all tickets were sold through travel agents, reducing these numbers would strengthen carriers' bottom lines.

One problem with the individual discounts offered by the airlines, though, was that their numbers were small and no one, not even travel agencies, knew how many were available. In addition, these fares came with restrictions that limited their applicability. Group discounts through travel agencies that later were resold to individuals had greater appeal to some customers. Taking advantage of group discounts, the travel service units of 15 major firms, including Nippon Steel Corp., Nippon Telegraph and Telephone Corp. and Honda Motor Co., Ltd., teamed up with Japan's largest discount travel company, H.I.S. Co., Ltd., to purchase domestic and international tickets. These were made available to company employees as well as sold to the general public.13

New pricing pressures emerged in January 1998, when the United States and Japan concluded a far-reaching agreement that removed all restrictions on transpacific flights by two passenger airlines and one all-cargo carrier from each country.14 The pact also granted these companies liberal or unrestricted rights to fly beyond the other country to regional markets. Equally important, as many as four other U.S. airlines were permitted to fly up to 90 new weekly passenger frequencies to Japan. Moreover, two new entrants providing passenger service were to be allowed in the market from each side, one immediately and another by 2000.

This sudden increase in transpacific capacity was bound to have a major impact on pricing and to fuel competitive pressures. To fill the extra seats, international discounts proliferated, pushed mainly by Japan's low-price travel agencies. Although it sold some discounted tickets, Japan's largest travel agency, Japan Travel Bureau, Inc., generally had stayed out of this market. But as JTB saw that approximately 30 percent of overseas tickets regularly were being sold by discounters, it decided to join the game. The company announced in early 1998 that it, too, would market low-price tickets at its 634 branches and affiliates.

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Slot Constraints Limit Competition

Despite the considerable loosening of MOT regulations governing fares and routes, capacity constraints at Tokyo's Haneda and Narita airports and at Osaka's Itami limited carriers' flexibility. Additional flights to accommodate the increased volume of passengers drawn by lower prices could not be contemplated as long as the number of flights through the nation's main airports was fixed. Likewise, the entry of new airlines into both the domestic and the international market was all but impossible.

The opening of Kansai International Airport was intended to increase takeoff and landing slots in the Osaka region since the airport, built on a manmade island in Osaka Bay, could be operated with fewer restrictions to curb noise and air pollution. MOT aviation authorities had planned to close Itami in due course, but local business interests pressured the government to preserve the older facility. It continues to handle mainly domestic flights. Most of Itami's international flights were transferred to Kansai, which had been planned as a hub linking international and domestic flights. The decision to keep Itami open not only foiled this plan but also made transfers in Osaka between international and domestic flights an ordeal of several hours.

A new offshore runway at Tokyo's Haneda Airport was scheduled for completion in early 1997. This facility was expected to allow 40 or so more takeoffs and landings a day as well as round-the-clock operation because its isolated location would mean reduced noise. In September 1996, MOT aviation policymakers alluded to the possibility of assigning some of the extra Haneda slots to new users, possibly for late-night connections from Kansai or Sapporo. One of the people most interested in these comments was Hideo Sawada, the president of H.I.S. He had concluded that for a new carrier to be viable, the one necessary requirement was access to slots in the Tokyo area.

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New Airlines Increase Competition

Mr. Sawada had attended a German university and, as a student, had traveled extensively in Europe and Africa. In 1980, at the age of 29, he founded H.I.S. and pioneered the practice of purchasing large blocks of group tour seats directly from carriers and reselling them to individuals. H.I.S. and other discount travel agencies routinely negotiate with airlines to buy blocks of seats that number in the thousands. Such transactions transfer the risk of holding unsold seats from an airline to a travel agency, which can be stuck with excess inventory or be forced to sell below cost if demand does not match expectations. Profits can be earned if the bargain tickets are resold above the prices paid by the travel agency. This kind of middleman-wholesaling was not covered by existing MOT rules. It would be instrumental in bringing down the ministry's elaborate regulatory structure. H.I.S. went public in 1995. A year later, it was Japan's second-largest travel agency behind industry leader JTB.

In December 1995, Mr. Sawada and a venture capitalist friend, Junichi Okawara, met with several other like-minded colleagues to plan a new carrier, eventually named Skymark Airlines Co., Ltd. By then, MOT policies on fares and multiple tracking seemed to presage a general willingness to consider more radical liberalization moves. Messrs. Sawada and Okawara had first discussed starting an airline in 1991, but at that time, the feasibility of such a venture seemed to be near zero. In the mid-1990s, they sensed new currents in the air, especially after MOT officials had intimated in the fall of 1996 that they would change the procedures for allocating slots at an expanded Haneda.15

According to subsequent comments by the Aviation Bureau's Katsuhiko Nawano, MOT indeed was inviting responses from potential new entrants. "We had been hearing rumors that companies like Toyota [Motor Corp.], which has to shuttle its employees between plants, wanted to enter the market. When I heard of Skymark, I thought, 'finally.'" Mr. Okawara later reported that when he asked about the possibility of getting Haneda slots for a start-up, Mr. Nawano told him, "I am pro-deregulation, so go for it."16

The press got wind of the Skymark venture while the entrepreneurs still were working out the details. Consequently, the group was forced to go public with its intentions in October 1996 — before a business plan was fully developed. The initial strategy called for a Tokyo-Sapporo fare that was half the standard ticket price. The group took as its models America's Southwest Airlines Co., which had grown into a low-cost alternative in the U.S. market, and Great Britain's Virgin Atlantic Airways Ltd., which combines low fares and high levels of service on international routes.

Skymark's strategy was to avoid as many fixed operational costs as possible, especially while the airline still was new. It would lease rather than buy aircraft, outsource maintenance and use the H.I.S. network of travel offices as a sales force and reservations management system. Furthermore, it would be a no-frills operation, eliminating meals and such amenities as warm towels and newspapers from its in-flight services. Finally, since Japanese pilots are among the highest paid in the world, foreign pilots would be hired to save on personnel costs.

A major concern of transportation authorities — and, ultimately, the flying public — was whether Skymark could ensure the operational safety of its planes if it outsourced maintenance. MOT agreed to allow the start-up to farm out major inspections and maintenance, but it required the carrier to inspect its fleet daily and perform any necessary maintenance as well as oversee the contract servicing.

Skymark had attracted initial investments from Mr. Okawara, who later became its president, H.I.S., Japan's top leasing firm, Orix Corp., cellular phone retailer Hikari Tsushin, Inc. and Masao Ogura, former chairman of Yamato Transport Co., Ltd., the country's biggest door-to-door package delivery service. This lineup of investors included several companies and individuals that earlier had gone head-to-head with Japan's regulatory authorities. As a result, they brought to Skymark the advantage of their experience in dealing with the bureaucracy in addition to their money and their commitment.

A new aviation regime clearly was in the works. Shortly after the Skymark announcement, several other groups declared their intent to get into the industry. At the end of October 1996, a spokesperson for a Hokkaido business consortium unveiled plans to form a new carrier. Hokkaido International Airlines Co., Ltd. would bring low-cost transportation services to Japan's northern island, the lack of which, the backers said, had stifled regional growth. The following month, a group of Okinawan firms under the leadership of the Naha-based Bank of the Ryukyus, Ltd. disclosed its idea of launching service between Okinawa and Osaka and Fukuoka.

In February 1997, several former executives of defunct Pan American World Airways Co. announced plans for a Fukuoka-based company to fly domestic and international routes under the name of Pan Asia Airways. Moreover, a Tokyo company called Japan Pacific Airlines applied for a license in October 1997 to fly between Tokyo and Fukuoka, but the scheduled launch of service was postponed in 1998 because of funding difficulties.17

Other start-ups also were announced, but little was heard from them after their first press releases. In the four-plus years since the first announcement, only two new companies actually have begun service, Skymark and Hokkaido International Airlines, now better known by its nickname, Air Do.

Skymark was licensed in July 1998 and inaugurated service with a single plane in September. It contracted for maintenance work with ANA, which insisted that the relationship was strictly a business deal on which it made a profit. The new carrier also used ANA's airport personnel to run its check-in counters. ANA staff simply change uniforms for their shifts at the Skymark gate.

Instead of competing with Air Do on the Tokyo-Sapporo run, Skymark started off with three daily round-trip flights between Tokyo and Fukuoka at a fare of ¥13,700 ($125), or half the regular price on that route. Its initial plans included moderate price increases after a year or so, by which time it would have established itself as a reliable alternative to the major players. Skymark added a second plane and in April 1999 inaugurated new routes linking Osaka to Fukuoka and to Sapporo. In December 1998, Air Do launched three daily round-trips between Sapporo and Tokyo, charging ¥16,000 ($145) one way, or 36 percent less than the standard fare of ¥25,000 ($230).

Around this time, the business press in Japan finally took notice of the fact that the actual fares paid by many travelers were averaging around 65 percent of the standard fares. Analysts started to wonder how the new carriers could survive if all they had to offer were low fares. JAL, ANA and JAS had several advantages. They possessed established brand names and offered convenient schedules throughout the day. Because they operated hundreds of aircraft, a problem with one plane would not disrupt the entire flight lineup. Perhaps most important, the Big Three went head-to-head with the newcomers by dropping prices to the same levels as those of the entrants on competing flights.

Skymark's load factor — the proportion of available seats occupied by paying passengers — was a highly satisfactory 70 percent in its first month of operation and climbed to a spectacular 90 percent in November 1998. The load factors of ANA, JAL and JAS on the Tokyo-Fukuoka route had been 60 percent, but they fell below 50 percent after the start-up's debut. Moreover, Skymark's Boeing 767-300 planes each were fitted with 37 more seats than the same aircraft flown by ANA.

The honeymoon ended for Skymark in early 1999. By April of that year, its load factor had dropped to about the same level as that of its competitors — under 60 percent, which was below its break-even point. Nevertheless, the company stated that it would keep its low introductory fares and not raise them as originally planned.

ANA was able to lift its load factor through discounts, but more than 70 percent of its passengers on routes that competed with Skymark had purchased tickets that cost half or less than half the normal fare. In June 1999, Skymark's load factor fell to 46 percent, forcing a hike in its Tokyo-Fukuoka fare by ¥2,300 ($20) to ¥16,000 ($145) to make up for the declining revenues. The airline's newer route between Osaka and Fukuoka also experienced a declining load factor, which had dropped to 40 percent by mid-1999. However, when its competitors ended their discount war for the summer holiday season, Skymark's occupancy rate bounced back up to 85 percent.

A top executive of Air Do described to a Sapporo business audience in May 1999 some of the trials of starting a new airline in what had been a highly regulated industry. Despite MOT's desire to promote new services, policymakers could not easily shake the habits of the past 50 years.

At first, the ministry tried to convince the carrier that it should confine its operations to Hokkaido. When Air Do refused to consider that course, MOT requested that the airline's Sapporo-Tokyo fare be raised about 10 percent (also refused) and that the company calculate its break-even point at a 65 percent load factor, the standard among established companies.

Air Do had planned to hire six pilots to fly a like number of daily one-way flights, which would have given the airline more than enough reserves. MOT required that it hire 16 pilots. When Air Do tried to lease a plane from Cathay Pacific Airways Ltd., the Hong Kong airline said that it would do so only if it got approval from JAL, which it did not receive. Air Do finally was able to find a willing partner in Australia's Ansett Worldwide Aviation Services, the world's third-largest aircraft leasing company.

Air Do's initial load factor was above 80 percent, but the Hokkaido airline suffered from the same competitive counterattacks as Skymark did, and its load factor fell to 45 percent in June 1999. The carrier received a major infusion of cash in February 1999 to help carry it over the inevitable money-losing initial period when Kyocera Corp. invested ¥500 million ($4.5 million), becoming the largest shareholder with more than a 10 percent ownership stake. Air Do's other main investors include thousands of Hokkaido businesses and individuals. Moreover, it is actively supported by local governments, which direct their employees to use the new carrier. Still, some analysts wonder how far regional enthusiasm can go in supporting an airline flying in the headwinds of ever-stronger competitive forces.

For its part, Skymark launched a business-class service in April 1999 at the fixed price of ¥8,000 ($70) above the regular fare; it also introduced a half-price child's ticket. To generate even more revenues, the carrier leases the sides of its planes for advertising and offers various product promotions to passengers. Not to be outdone, Air Do introduced an ¥8,000 ($70) fare for people under the age of 22 and special fares for disabled passengers.

Maintenance remains a problem for the start-ups. Skymark's contract with ANA was jeopardized when a major cost-cutting drive at the larger airline caused staff reductions and ANA claimed that it no longer had the capacity to service the newcomer's aircraft. Air Do had a similar arrangement with JAL, which, after a time, also expressed reluctance to help its new rival. In April 1999, the Transport Ministry stepped in, warning the bigger companies not to cut off service and ignore "ministry guidance."18

Skymark and Air Do still face sizable hurdles in their attempts to compete in what now is an almost completely deregulated Japanese market. After raising their load factors in the summer of 1999, full-scale price competition resumed. In April 2000, Skymark announced that it was terminating the three daily flights on each of its routes linking Osaka with Fukuoka and Sapporo. However, the carrier said that it would increase daily operations between Fukuoka and Tokyo's Haneda when new slots become available.

Skymark also entered into a marketing pact with one of the country's largest travel agencies, Kinki Nippon Tourist Co., Ltd. The carrier plans to launch international charter flights from Fukuoka to Seoul in 2001 with about 200 flights annually. Eventually, it wants to switch these flights to a regularly scheduled service. Skymark still must gain MOT approval for its charters.

To expand, though, the company needs money. Skymark plans to raise funds through the Tokyo Stock Exchange's New Market of High Growth and Emerging Stocks, more commonly known as MOTHERS (see JEI Report No. 42B, November 5, 1999), where its shares were approved in May 2000. However, the carrier has not yet sold the 5,000 shares it intends to offer the public.

Mr. Okawara, one of Skymark's founders and top executives, recently left to form a regional airline, Fair Inc., which will run three daily flights between Osaka and Sendai. Operations are scheduled to begin in August 2000 with fares in the range of ANA's. In fact, ANA will help the new firm with sales, maintenance and crews. Fair plans to fly small aircraft to local airports in Miyagi prefecture and elsewhere and will concentrate on business travelers who otherwise would have to make connections at metropolitan airports. Given its focus on serving smaller airports, Fair will not compete directly with the three big carriers, which should make it easier to gain their cooperation.

Skymark, Air Do and other planned carriers may or may not succeed. Indeed, the American experience has included several failures. However, some U.S. start-ups do find a business plan that works. A new sense of experimentation also is apparent in Japan's aviation industry. However, attempts to try out different approaches still are hamstrung by the shortage of slots at Japan's major airports. Tokyo takeoff and landing rights, industry observers say, are absolutely necessary for a carrier to survive.

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Complete Price Deregulation Slated For 2000

In February 2000, a revised Civil Aeronautics Law, passed by the Diet in June 1999, went into effect. It eliminated regulations on domestic airfares and gave airlines a free hand in determining their routes and flight frequencies. The revamped law follows a 1998 cabinet decision to eliminate supply management in the transportation business more generally.

ANA was first out of the starting block with its January announcement of a new pricing structure. Interestingly, the top domestic carrier's regular, unrestricted, nonpeak fares are 15 percent higher than the previous standard fares. At one time, MOT officials were fond of pointing out that published fares in Japan were lower than full fares in the United States. Usually left out, however, was any reference to the fact that more than 90 percent of American travelers buy tickets at discounts that average 65 percent off list prices but range as high as 90 percent.

The benefit of maintaining high published fares is that it gives airlines more pricing flexibility. This fact helps to explain ANA's higher fare structure. Indeed, ANA projected in its announcement that 95 percent of its customers would be able to take advantage of discounts compared with the 70 percent who were doing so before February. As an experiment, the airline introduced a superdiscounted fare for 10 specified days in April and May, when all seats not purchased during the reservation period (two months before the flight date) would be priced at a flat ¥10,000 ($90) on every domestic route ANA serves. For the flight from Sapporo to Fukuoka, for example, this price amounted to a 77 percent discount.

Other domestic airlines came up with fares and discounts comparable to ANA's, but each had a different wrinkle. JAL, for example, offered 15 percent off any trip booked over the Internet. It predicted that 80 percent of its passengers would take advantage of the lower prices.

The changed regulatory environment resulted in new problems for the start-ups, however. Air Do said that it would offer reduced prices on two of its six daily flights. Skymark suggested that it may have to do some discounting from its all-the-time low fares, but the carrier clearly is reluctant to make this move since the simplicity of its fare structure is one of its selling points.

ANA's superdiscount program was so successful that it will be repeated in the July-September period. The carrier also will introduce discounts on routes that compete with high-speed Shinkansen (bullet train) rail services. This pending change is recognition of the fact that on many of Japan's most heavily traveled corridors, most people go by train.

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Remaining Slot Issues

As has been discussed, insufficient takeoff and landing capacity at Japan's major airports affects the vitality of both the international and the domestic airline business. The January 1998 bilateral aviation agreement contemplated a large number of extra flights by Japanese and American carriers alike. At first glance, it had seemed that a few new Narita slots, plus Osaka's Kansai airport and service to other cities around the country, would satisfy the needs of the new frequencies. Access to Narita International Airport, though, clearly was the plum for all parties.

Many aviation experts figure that Narita can increase daily flights by 25 percent or more, notwithstanding its single runway and the limited hours of operation imposed on the facility by noise and environmental restrictions. However, even assuming that Narita's air traffic controllers could be persuaded to handle more planes, it is apparent that the desired number of flights exceeds the airport's theoretical capacity.

A second runway planned for Narita, expected at the time of the latest U.S.-Japan aviation agreement to be completed in 2000, would increase slots by some two-thirds; that could satisfy most of the latent demand. Moreover, like many other countries, Japan has a "use it or lose it" rule on slots. Tokyo proposed reassigning to other American carriers takeoff and landing rights at Narita that had been allocated to Federal Express Corp. but were not used by the overnight delivery company. Airport authorities also managed to find other underutilized slots at Narita — for example, capacity that had been set aside for trips by the royal family and high government officials, or slots used intermittently by domestic and foreign companies, including FedEx, for seasonal peaks. These also were open for redistribution. In all, Narita managers came up with 202 extra takeoff and landing slots; they authorized 70 to 80 additional flights a day.

Work on Narita's second runway ran into a major snag in April 1999 when holdout landowners refused to sell property in the middle of the construction site. MOT abandoned the projected 2000 opening date and settled on a new plan to build a shorter runway, one that bypasses the unavailable land. The start of service on the second runway now is scheduled for June 2002, in time for the World Cup soccer matches to be held jointly in Japan and South Korea.

Meanwhile, the new runway at Haneda is expected to be operational this summer. The number of flights there should increase to 351 a day from 320, a third more than planned two years ago. Studies of Haneda's air traffic control system persuaded airport authorities that additional flights could be squeezed out of the facility. A target of 377 daily flights has been set for July 2002.

The key issue was how to divide the new capacity. MOT rejected the idea of auctioning off the slots because of fears that one major carrier would grab all of them and gain a near-monopoly on traffic at Haneda. At the same time, though, the ministry has been criticized for using a nontransparent allocation system, one that can be abused. In fact, slot assignments are among the few aviation regulatory functions still under the Transport Ministry's control.

To remove some of the arbitrariness of this process, an advisory committee developed a point system based on airline operations and how well carriers served the public interest. The 31 slots that will become available this summer were allocated according to this new formula. Japan's start-ups received 17 of the slots.

Another issue being raised for the first time in years is whether to open Haneda to international traffic. Before Narita was built, Haneda had served both domestic and international flights. Those services now are separate, which makes transfers a hassle involving several hours of ground transportation. Tokyo is debating the possibility of using some of the new capacity to make Haneda a more convenient hub.

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Restructuring Costs And Finances

The covers of the English-language versions of JAL's and ANA's annual reports for FY 1998 summarize the main internal problems facing Japan's two biggest airlines. JAL's publication carries the caption, "A More Competitive JAL Group." The ANA headline reads, "Action — A progress report on ANA's restructuring plan." JAL has made the greatest strides toward reducing its unit costs from levels that even its chief executives have acknowledged were among the world's highest. Since three-quarters of the airline's revenues come from foreign operations, the strength of the yen has colored cost comparisons with foreign carriers, but even in dollar terms, JAL's achievements are significant.

JAL reduced total costs by 30 percent between FY 1990 and FY 1998; labor costs shrank by an even larger 40 percent. Unfortunately, yields fell even faster — 35.5 percent on the airline's most important international routes and 29 percent on domestic operations. The International Civil Aviation Organization calculates standardized cost data for the world's major carriers. It shows JAL's costs falling to 48 cents per available ton-kilometer in 1998 from 68 cents in the early 1990s. The new cost structure is within shouting distance of United Airlines' 44.2 cents for 1997.19

JAL became more efficient in the usual ways. For example, it has reduced ground staff by more than a third since 1991. In addition, it has been hiring flight attendants on a contract basis only and at wages considerably below the old standard. The company had planned to cut costs further by using foreign staff, but MOT intervened, arguing safety issues. JAL also formed a low-cost subsidiary to fly vacationers to Southeast Asia, hiring cabin crew in Thailand and pilots in Ireland, Great Britain and elsewhere. The foreign pilots are based in Hawaii, and the attendants return to Bangkok on their days off, which is more cost-effective than basing staff in Japan.

A money-losing hotel chain, expanded during the "bubble economy" years of the late 1980s, was sold off, with JAL taking a one-time charge. The carrier also is stretching out its aircraft deliveries to conserve capital. Moreover, it is using its available cash flow to reduce debt by ¥350 billion ($3.2 billion) by 2002 in order to cut interest expenses.

ANA has not been as ruthless as JAL in trimming staff, but the carrier did provoke a pilot strike on its international routes in 1998 when it tried to revamp a guaranteed payment scheme, whereby pilots were assured of at least 65 hours of pay a month regardless of their actual working time. After almost two months, the pilots returned to work, apparently because of low public support and the weak financial condition of their employer. ANA has been more successful in reducing unneeded capacity. It has delayed deliveries of planes and moved some equipment to a low-cost subsidiary.

At present, most of ANA's cost-cutting schemes are future-oriented. The carrier has focused on flying more passengers through aggressive fare cuts and by taking advantage of its incumbent status on transpacific flights, where it now has the same route flexibility as JAL. During the East Asian financial and economic crisis that began in mid-1997, ANA was able to increase its service to several American destinations. At the same time, membership in the United Airlines-led Star alliance has given ANA important code-sharing relations that have boosted transpacific sales over those of other segments.

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Conclusion

These moves by JAL and ANA indicate that deregulation and increased competition are having a predictable effect. Japan's high-cost, inefficient and, thus, expensive aviation industry is a relic of a changing regulatory system. As competition heats up even more with the opening of new slots at major airports, the pressure only will get fiercer. To date, no Japanese carrier has called it quits, but that may not be true in the future.

Kanako Yamada provided research assistance.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

*** JEI Report will not be published June 2, 2000 because of the Memorial Day holiday. ***
*** The Next Issue will be dated June 9, 2000 ***
 

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Notes
aaa

1aa For more details on the development of Japan's air transport industry, see Arthur J. Alexander, "Domestic Aviation In Japan: Responding To Market Forces Amid Regulatory Constraints," JEI Report No. 12A, March 29, 1996. Return to Text

2aa Shares are measured in terms of revenue-passenger-kilometer, or the actual number of paying passengers multiplied by the flight distance they are carried. Return to Text

3aa Alexandra Harney, "Airlines Get That Sinking Feeling Over Japan," The Financial Times, November 30, 1999. Return to Text

4aa "Transport Ministry to Cut Landing Fees at Local Airports by One-Third," The Nikkei Weekly, August 10, 1998. Return to Text

5aa "Japan's Cautious Airline Deregulation: How Far Will It Go?" The Oriental Economist, June 1985. Return to Text

6aa Patrick Killen, "A Tale of Two Airports, or Three," The Journal of the American Chamber of Commerce in Japan, February 2000, p. 16. Return to Text

7aa "System is sought to cut air fares, end discount war," The Japan Times, June 16, 1993. Return to Text

8aa "New fare rules may hurt discounters," The Japan Times, February 23, 1994. Return to Text

9aa "Kansai Warming," Aviation Week & Space Technology, January 23, 1995. Return to Text

10aa "Fare Rules Loosened for Domestic Flights," The Nikkei Weekly, December 5, 1994. Return to Text

11aa "Unfettered Air Fares Fly Higher," The Nikkei Weekly, February 26, 1996. Return to Text

12aa "Japan's Airlines Introduce Competitive Fares Bit by Bit," Aviation Week & Space Technology, February 26, 1996. Return to Text

13aa "Nippon Steel, NTT, Others to Sell Discount Air Tickets," Nikkei Net Interactive, August 4, 1997. Available at http://www.nni.nikkei.co.jp. Return to Text

14aa See Arthur J. Alexander, "Transpacific Aviation Pact Yields Extensive Opportunities," JEI Report No. 7A, February 20, 1998. Return to Text

15aa Sandra Sugiwara, "Japan's 1st No-Frills Airline Steers to Uncharted Territory," The Washington Post, February 10, 1997. Return to Text

16aa Ibid. Return to Text

17aa "Competition Takes Off With New Airlines," The Nikkei Weekly, July 6, 1998. Return to Text

18aa "New Airlines Face Pressing Maintenance Issue," Nikkei Net Interactive, April 9, 1999. Available at http://www.nni.nikkei.co.jp. Return to Text

19aa "Japan Airlines Rights Itself Through Cost Cuts," The Nikkei Weekly, February 7, 2000. The cost per available ton-kilometer measures how much it costs to carry one metric ton — including plane, passengers, fuel and cargo — one kilometer. Return to Text

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

*** JEI Report will not be published June 2, 2000 because of the Memorial Day holiday. ***
*** The Next Issue will be dated June 9, 2000 ***
 

Top aaaa Issue Index aaaa 2000 Archive Index aaaa Subscriber Area aaaa Home