Cathay’s great coup stands to begin a radical shakeup of the overall China air service market. On first read it may seem largely to address the needs of Hong Kong’s de facto flag carrier and the future of Dragonair, but its implications go far beyond simply their futures.

It affects two of China’s major players: Guangzhou-based China Southern Airlines and Shanghai-based China Eastern Airlines. They are paying very close attention, for if they are to remain real competitors and ensure their home bases develop further as hubs, these two will now need to find foreign partners of their own – and they should waste no time trying to do so.

The multi-billion-dollar deal will see Cathay acquiring all of fellow Hong Kong-based Dragonair, which operates most of its services into mainland China. Cathay has had great trouble securing rights to boost its limited China operations and in one bold move gets a sizeable Chinese network.

Cathay will buy the Dragonair shares from China National Aviation (CNAC), which is a subsidiary of Air China, CITIC Pacific and Swire Pacific. In return Air China and CNAC will acquire a joint 17.5% stake in Cathay. Cathay, which acquired 10% of Air China late in 2004, will double its stake in the Beijing-based flag carrier to 20%.

The deal could lead to a wider shakeup in the Chinese market, where the government has been allowing new airlines to launch domestic operations, existing second-tier airlines to expand their fledgling international networks, and foreign airlines to dramatically increase services to the country.

It is a win-win for Cathay and Air China, as well as for their respective home bases. It is also a win for Hong Kong’s emerging new carriers, which should now be able to expand their operations. A new air services agreement is expected to be announced soon between Hong Kong and China.

But it is potentially bad news for China Eastern and China Southern, both of which have already been facing new competition at their respective home bases. Both are losing money and badly need to improve their operations, but both have been slow to act in restructuring to prepare for the future.

It is no accident that Air China is the only one of the “big three” carriers to be making profits – it has been working hard to cut costs in an environment where high fuel prices are impacting every airline. It has also been more willing to learn from the experiences of foreign airlines, such as well-managed Cathay. It is in part for this reason that the Chinese government has let it grow and partner with Cathay as well as join the Star Alliance – even if it is at the expense of China Eastern and China Southern.

China Eastern is facing particularly significant challenges. It has a fast-growing competitor in the form of Shanghai Airlines, which also plans to join Star. In addition, China is giving foreign airlines far more rights to serve Shanghai. For years Cathay was seeking to get closer to it and tried at one point to buy in. Cathay eventually gave up and bought 10% of Air China. It proved a great strategic move, and left a stunned China Eastern without an obvious strategy in a fast-changing airline world.

However, China Eastern still has plenty going for it. Shanghai is China’s commercial capital, which makes the dominant home-based airline an attractive potential buy-in target for foreign carriers. China Eastern should now open the door to negotiations, or at least open up to joining the oneworld alliance, given that China Southern has already committed to SkyTeam.

For Hong Kong and China this is a long-awaited move as things have been farcical for far too long between the two sides with respect to airline operations. Hong Kong is a Special Administrative Region of China yet Cathay is only allowed to operate a tiny number of services to China each week. For example, it is not even allowed to serve Shanghai with its passenger aircraft.

With the deal between Air China and Cathay featuring detailed co-operative ties, as well as with Dragonair, the hubs of Beijing and Hong Kong should benefit, as the already strong airlines will provide feed to each other.

The fallout from this deal will be felt for years, as Air China and Cathay tighten their links and as Cathay incorporates Dragonair’s large China network. Carriers that do not see this deal as something with implications for more than just the direct players will have the most to worry about in the years ahead. ■

Source: Airline Business