US-Japan Civil Aviation: Prospects for Progress

Civil aviation has always been an industry rife with trade disputes between the United States and Japan. International civil aviation is currently regulated through a series of bilateral treaties. In 1997, negotiations will be conducted on the US-Japan civil aviation treaty. The Institute for International Economics in Washington, D.C. held a dinner on February 13, 1997 entitled "US-Japan Civil Aviation: Prospects for Progress". The key speakers were Dr. Hirotaka Yamauchi from Hitotsubashi University, U.S. Department of Transportation Deputy Assistant Secretary Patrick Murphy and Dr. Christopher Findlay from the University of Adelaide.

This meeting provided a forum for leading civil aviation experts from business, government and academia to propose possible steps that can be taken to further open the industry to competition, while satisfying both US and Japanese concerns. The meeting was inspired by the joint IIE-Australia-Japan Research Center (AJRC) volume Flying High: Liberalizing Aviation in the Asia Pacific, edited by Gary Hufbauer and Christopher Findlay.

History

Current US-Japan civil aviation regulation is based on a treaty concluded in 1952. This treaty has three main features. First, it allows designated carriers unlimited capacity rights. That is, the carriers can increase or decrease flights per week or type of aircraft without limit or need for prior approval. Second, the treaty designates gateway cities. Carriers can depart from any home city but are required to land at only designated cities in the partner country. Lastly, the treaty grants US designated carriers unlimited "beyond rights". That is, the US carriers are not restricted to carrying traffic originating in the United States on flights beyond Japan.

Not all carriers have the rights stated above. Carriers given rights under the 1952 treaty are known as incumbent carriers. Those carriers which subsequently acquired rights in memoranda of understandings (MOUs) signed in the 1980s are called MOU carriers.

Currently, there are five general categories of carriers: US incumbent carriers - United Airlines (UA), Northwest (NW) and Federal Express (Fed Ex); one Japanese incumbent carrier - Japan Airlines (JAL); US MOU carriers - American Airlines (AA), Delta, Continental and United Parcel Service (UPS); Japanese "MOU" carriers - All Nippon Airways (ANA) and Nippon Cargo Airways (NCA); and those carriers currently with no rights to fly in the region.

Japan-Hirotaka Yamauchi

It is essential for Japan to pursue deregulation of civil aviation in both the domestic and international arena. The industry is currently over-regulated and lacks efficiency. Deregulation, however, should be done slowly and methodically because the nature of the industry and the current US-Japan bilateral treaty.

The Japanese Ministry of Transportation has taken measures to increase competition in domestic civil aviation.¹ In the international arena, deregulation has not been as actively pursued because of the nature of the industry and the current US-Japan bilateral treaty which favors US carriers.

The civil aviation industry is more difficult to deregulate internationally than other industries. High barriers to entry in civil aviation distort regular market forces. The industry is also important for national security and often, especially for smaller countries, national prestige.

The current status of the US-Japan treaty with the various MOUs is as follows:

• The treaty is "legally unfair" in its text with regard to "beyond rights".


• The treaty is "in results unfair" with regard to the number of incumbent carriers.


• It is unclear to what extent legal unfairness results in economic unfairness, but probably not much.²

Japan believes that treaty rights should be equalized before further liberalization occurs.

As the current situation stands, it could take a long time to deregulate the market. For liberalization to occur, a common interest in deregulation by carriers in both countries must exist, or one side must concede. Partnerships between US and European carriers have resulted in deregulation of those markets. Similar partnerships, however, between US and Japanese carriers have not occurred.

The United States could unilaterally agree to allow JAL to have unlimited beyond rights from US airports and allow ANA to become an incumbent carrier under the 1952 treaty. Until now, the United States has refused to allow an increase in the number of Japanese incumbents. Equalization would not hurt US carriers because the number of economically viable beyond rights routes for Japanese carriers is small, and Japanese airport constraints would limit the number of new flights from Japan. The United States would gain from this unilateral concession, because Japan could no longer claim that the existing treaty is unfair in the course of subsequent negotiations.

Instead of taking unilateral action to equalize treaty rights, the United States is currently using the two issues - beyond rights from US airports and the number of Japanese incumbent carriers -- as bargaining chips in negotiations with Japan. The Japanese, in turn, are using creative interpretation of the 1952 treaty to limit US beyond rights.

The issue of beyond rights is vital to an understanding of future negotiations. The United States claims that the network of beyond rights provided to US carriers can be duplicated by Japanese carriers flying through Asia to the United States. This argument, however, wrongly interprets the legal argument and misses the economic argument. Legally, US rights beyond Japan to Asia should be compared to Japanese beyond rights to Latin America or Europe. Economically, US beyond rights to Asia should be compared to Japanese obtaining cabotage rights within United States. The size of the US market and distance from Latin America and Europe make these comparisons more appropriate in economic terms. Therefore cabotage rights must be considered.

A multilateral approach to liberalization may be the best way to pursue deregulation. Strong leadership, however, is important as well as US agreement to liberalize its domestic market to international competition. Perhaps a gradual multilateral approach, based on grouping together regional or bilateral liberalization agreements, would be a viable approach in the future.

United States-Patrick Murphy

Aviation has achieved the dubious distinction of being labeled as the most contentious bilateral economic problem between the United States and Japan. Even though opening the market would benefit Japan the most, Japan seems committed to maintaining protection in civil aviation, an industry where its cost levels are not currently internationally competitive. Thus the United States must once again fight to gain access to the Japanese market.

Japan argues that the US-Japan civil aviation treaty is unfair because it was signed in 1952 by a defeated power. Japan states the treaty is unfair due to the larger US market share, greater US beyond rights, and the larger number of US incumbent carriers.

Both countries, however, had similar market shares from 1970 to 1986. Only after 1988 did the US market share increase, as US carriers began implementing market efficiencies learned from domestic deregulation.

With regard to claim that the United States has superior beyond rights, it is true that the United States has vast rights beyond Japan into Asia. Japanese carriers, however, have similar access to Asia, where they carry significant traffic to the United States via Japan.

Lastly, the unequal number of incumbent carriers is a situation created by Japan. The original treaty did not limit the number of carriers. Rather, in the 1980s, Japan insisted that additional US carriers (and therefore, additional Japanese carriers) entering the market would have to operate with more limited rights.

In treaty negotiations, Japan strives for improved rights to the United States for Japanese carriers such as ANA, while further limiting the rights of US carriers. Recently, Japan has proposed expanding US beyond rights in proportion to the increase in traffic. The United States opposes this proposal, because it would maintain US carriers at a fixed market share, which in turn would inhibit competition in the market. The United States instead advocates a full market-opening agreement, whereby debates over unfair 1952 treaty rights would be inconsequential.

Thus, the situation returns to the classic position of the United Sates requesting market liberalization and Japan seeking protection. In the past 20 years, this position has lead to three different strategies. First, both countries would disengage, refusing to speak about aviation issues. Next, when demands from carriers of both countries became louder, aviation trade disputes would occur. Lastly, there would be a modest agreement reached with both countries gaining some rights. The United States believes that the current situation is ripe for a departure from this pattern. The United States and Japan should negotiate a comprehensive open market agreement.

Three new options for making progress in the negotiations have been proposed in the United States. It has been suggested that linking civil aviation to other sectors would provide leverage to bring about open markets. The second proposal is that the United States should attempt to liberalize by using the auspices of a multilateral forum, such as the Asia Pacific Economic Cooperation (APEC). In the past, however, multilateral processes have proved to be quite slow and the Japanese currently oppose inclusion of aviation in multilateral agreements. At the APEC Summit in Manila, the Asian countries agreed to liberalize the service sector. Japan, however, is using several forums, including APEC and OECD, to achieve an exclusion for aviation from this commitment. A third recommended option is to move to bilateral market liberalization. Liberalization could be phased to match new airport capacity. Alternatively, certain sub-sectors could be liberalized first, such as cargo.

New economic forces are also at work, pushing the international air transportation environment towards liberalization. US deregulation started a global change in aviation. New market forces are leading to the development of global networks. The Japanese domestic market is embarking on deregulation. The Japanese press has reported on the formation of three new airlines in a market where domestic entry has not occurred for 43 years. In April 1996, the Japanese Ministry of Transportation (MOT) gave Japanese carriers greater flexibility in setting lower domestic fares. The United States has entered into an "open skies" agreement with many countries including several in Asia. Lastly, US-Japan aviation disputes have reached a level where the president and prime minister have addressed them.

Australia-Christopher Findlay

As demonstrated by the foregoing exchange, the United States and Japan are entangled in a bilateral dispute over civil aviation. Various options for resolving the conflict exist. After discussing the current restrictive environment, I will suggest some options which may allow both parties to obtain a desirable outcome.

Despite the current inefficient system of bilateral aviation agreements, strong forces in the market place are creating increased competition. There are more routes, more destinations, and more airlines, especially in the rapidly growing Asia Pacific region. In response to this competition, airlines have joined alliances to overcome the obstacles created by restrictive bilateral treaties. By comparison with an alliance system, a global open skies regime would create more flexibility and faster growth which could potentially be even more lucrative to airlines. The trade off would be the loss of privilege by airlines which are established in markets with controlled entry.

Unlike most other industries, civil aviation has a higher potential for competition policy problems. Therefore, many countries, especially large ones, will be unwilling to make a unilateral declaration of free trade for fear of running a competition policy risk. A multilateral competition policy mechanism must be created to deal with this problem.

Though competition policy issues must be tackled, there are options to further liberalize trade which involve smaller initiatives than a unilateral declaration of free trade.

The first option is to do nothing. That is, Japan and the United States simply agree to disagree. As new airports open up in the rest of the region, and as new aircraft types offer scope to serve those points direct, Japan will diminish in importance as a hub into Asia. This solution is not preferred. It would be better if Japan could compete with other regional hubs. Further, we should be concerned about consumer interests on US-Japan flights.

The second option is to link the dispute to issues in other sectors. Bringing other issues to the same bargaining table would motivate a wider range of domestic groups to take a political interest in the outcome. The disputes might become easier to solve as more options become available. But, to link civil aviation to other sectors would require acceptance of the idea that the normal rules of the world trading system apply to this sector. So far this has not been acknowledged. A step in that direction would be for APEC to reiterate that its commitment to free trade is comprehensive and includes the transport modes. APEC could adopt a negative list approach to services, whereby Japan could temporarily continue to claim an exemption for civil aviation.

The third option is to establish arrangements within APEC whereby a group of like minded countries simultaneously establish a series of liberal agreements. It would be important to specify rules of membership for the group and new members should be able to join on the same terms as the current members. This amounts to a "club", not a bloc, solution. The APEC agreement could be presented to the World Trade Organization (WTO) as a draft of a separate multilateral agreement on air transport. An additional benefit of this approach would be that the disputes associated with the agreement could be subject to WTO procedures, a great improvement over the current arrangements which involve the threat of sanctions. Alternatively, APEC could consider its own dispute settlement system for the sector.

The fourth option is to treat cargo separately from passengers and liberalize it first. The results would be useful in assessing the costs and benefits of liberalization in the passenger market and would subsequently help provide an impetus for liberalizing the passenger market. Air freight liberalization could be part of a package of measures in a program which APEC might arrange to liberalize freight on all modes-land, air and sea. This liberalization would usefully complement the reforms in the telecom and information technologies sector that first APEC at Subic and then the WTO ministerial at Singapore endorsed. Telcom liberalization will boost electronic commerce in the region, and the cargo liberalization will facilitate the delivery of merchandise throughout the Asia Pacific. Bringing transportation liberalization to the APEC forum is consistent with the strategic notion that APEC can remove impediments to trade that have not been dealt with previously.

The fifth option is to relax ownership rules. This is already occurring in many countries. Removing barriers to foreign ownership of airlines would give Japanese airlines more options. If they could contract out more of their operations, or take equity in US carriers, Japanese airlines would be more likely to agree to other liberalization measures.

The sixth option is to establish a market in traffic rights. This option involves permitting trade in an important part of an airline's activities. It is often discussed in relation to airport slots when airports are congested. This procedure helps airlines adjust their systems and even enables them to cease operations and sell their rights. The market value of slots will inform airport planners about the market value of more capacity. If landing slots were not the binding constraint, but rather rules on capacity were the constraint, then leasing out of traffic rights could occur. The amount paid for these rights would be fascinating to observe. Again, this strategy would facilitate the adjustment of incumbent carriers. High cost carriers could take the money and run. Regulators or negotiators could focus their attention on the routes where higher prices for rights are observed.

Of this list, options 2 and 3 should be pursued with on grounds of principle. Option 4 -- free cargo services -- would be stunning and I propose it as a high priority for APEC. At the same time, option 5 on ownership rules could also be pursued, and might be caught up in any case to accompany investment liberalization agreements in the region. Some countries might be prepared to experiment with markets in traffic rights.

Question and Answers between the Audience and Speakers

Q: Why won't Japan agree to tear up the old 1952 treaty which enforces a limited framework and instead initiate a multilateral approach?

Yamauchi argued that the civil aviation industry is unique. Because of those features, the Japanese government should seek equal and balanced rights. Solving beyond rights alone will be difficult. Perhaps, an arbitration process could be established using a third party to resolve the beyond rights dispute, in conjunction with cabotage rights, Yamauchi suggested. One participant responded that if Japan really wanted equal opportunities, then the best way to get them would be to opt for liberalization.

This participant also discussed attempts to reach a multilateral outcome. He said the United States advocates moving from a bilateral to multilateral approach, but that US negotiators are now "battle scared veterans" of NAFTA and the GATT. Probably, the most successful multilateral approach would be through the APEC forum. APEC was successful at opening international trade via the International Telecommunications Agreement (ITA). Japan, however, is opposed to APEC having a role in air transport. Given these sorts of difficulties, the United States has agreed to work within the bilateral system.

Bergsten noted that APEC's importance was maintained after the Subic Summit due to liberalization in the high tech information technology sector. The ITA was a success because the industries involved wanted it. APEC is looking for other sectors in which to make liberalization a priority. The civil aviation industry should make a run. The dynamics of APEC summits are such that action is possible. Desiring a successful summit, Heads of State will push through legislation or reform that lesser government officials are reluctant to endorse.

Q: What do the panelists think about linking aviation to other sectors?

Yamauchi said that linking aviation to other sectors is not a good idea, because of the unique nature of the civil aviation industry. It has many technical and economic restrictions, unlike other industries. Findlay observed that it is somewhat more difficult, though not impossible, to link aviation with other sectors, because of the all-or-nothing nature of reform in any individual service sector. However any attempt to make a linkage should involve packages of liberalizing actions, rather than threatening to deny access in other sectors, he said.

Q: Is the civil aviation industry really special?

Yamauchi argued that the industry does have some features which make it special. These include substantial barriers to entry. National security and prestige are also associated with airlines. Findlay noted that the national status aspect of this sector is gradually weakening worldwide, as government ownership becomes less important. Industry participants argued that the industry does have other special characteristics, namely geography, government ownership, national security concerns, safety issues and the belief in some big economies ( 3 or 4 of the G-7) who feel that their industry is behind the game and want to slow liberalization. Reflecting these special features, a network of international agreements, arrangements and alliances also exists. Bergsten however noted that other industries, notably telecom and financial services were also argued to have special characteristics but those sectors have still produced multilateral agreements that point towards liberalization. Why couldn't the same happen in air transport?

Q: There is a substantial cost differential between US and Japan Airlines. If US carriers had high cost structures, would the US now liberalize?

In reply to the specific question, Murphy noted that the United States was prepared to liberalize the maritime sector, despite its comparative disadvantage in that sector. On the general issue, Yamauchi argued that market forces are the best way to reach an efficient outcome, but the concern in Japan is that Japanese airlines are not seen as competitive and this is a source of resistance to liberalization. Findlay noted that Japanese airlines had been slow to use the tactics employed by other airlines to deal with their loss of competitiveness, including alliances, outsourcing and relocation.

Bergsten then raised the question of whether the US carriers are so much more efficient that Japanese carriers couldn't even survive with liberalization? The same debate surrounded automobiles in the 1980s, and the US automobile industry did not disappear. It is important to look at the strengths and weaknesses of individual companies, not whole country. With liberalization, some companies in each country would be in trouble and others would prosper. Findlay noted that Japanese firms have the "hometown advantage." That is, Japanese carriers know their domestic customers-where they want to travel, when, how, etc.-and this information is a competitive strength. Members of the audience concurred. Both sides have advantages. US carriers have an advantage in cost structure and therefore are strong in point-to-point markets. Japan offers a hub to the fastest growing market in the world, Asia. By contrast, North America is a mature market. Growth opportunities for Japanese carriers are abundant. Within a bilateral agreement, both sides can exploit their advantages, members of the audience argued.

Q: Could US and Japanese companies join together and form a web of strategic alliances? In the past, sectors that experienced contentious disputes, such as automobiles and electronics, have moved from confrontation to cooperation through strategic alliances.

Findlay noted that alliances have advantages since they help get around bilateral arrangements. For example, if domestic market entry remains restricted, then various types of alliances offer a good way around the barriers. Members of the audience observed that not all alliances are benign (or simply "leap over regulations"). Some companies have market dominance as a consequence of their alliances. Other alliance problems arise from geographical and infrastructure barriers. For example, both Japan and the United Kingdom have unique infrastructure and geography. If an alliance is formed involving airlines from those economies, but exclude certain US carriers, then those carriers could not compete. It was observed that in the WTO Basic Telecommunications Agreement, there is an important pro-competitive component of the agreement to address competition policy.

Q: What is the panel's assessment of the US "Open Skies" initiative?

Findlay argued that "Open Skies" agreements are bilateral so they are discriminatory-they continue to exclude airlines from third countries. He asked whether the basic terms of all US "Open Skies" agreements are the same? The answer was "yes", but with many differences in detail. Findlay further suggested that a good test as to whether such agreements are truly liberalizing is whether the United States would promote the multilateralisation of such agreements. What about creating an open market by linking all "Open Skies" agreements, he asked? US officials agreed that was a good idea. Bergsten then asked whether "Open Skies" agreements could be stepping stones to APEC free trade in aviation? The response from the audience was that such agreements only deal with certain barriers. They do not deal with related areas such as cabotage and ownership. Hence, it would be better to design an agreement with broader subject matter coverage.

Concluding remarks by panel members included these observations:

The United States is no longer willing to sign a restrictive agreement with Japan and seeks to construct a more liberal environment in which large gains can be made (Murphy, as well as US industry participants).

The best way to achieve large gains is by reference to the principles of the multilateral trading system. Even so there remain a number of practical reform issues, but these are best dealt with via the instruments of competition policy, and not by retooling the current regulatory regime (Findlay).

Notes

1. Yamauchi, Hirotaka, "Air Transport Policy in Japan", Flying High, p.53.

2. Ibid.