CHINESE STATE-OWNED AIRLINE MOVES CLOSER TO

C O N F I D E N T I A L HONG KONG 001611

SIPDIS

STATE FOR EAP/CM

E.O. 12958: DECL: 08/26/2019
TAGS: EAIR ECON HK CH
SUBJECT: CHINESE STATE-OWNED AIRLINE MOVES CLOSER TO
CONTROLLING HONG KONG'S CARRIER

Classified By: Acting Deputy Principal Officer Martin Murphy for reason
s 1.4 (b) and (d)


1. (C) SUMMARY: China's State-owned Air China announced
August 17 it would purchase a 12.5% stake in Hong Kong's
Cathay Pacific Airways from another Chinese State-Owned
Enterprise (SOE),CITIC Pacific, for 6.34 billion Hong Kong
Dollars (about USD800 million). This acquisition will bring
Air China's stake in Cathay to 29.99%, the second largest
after Hong Kong-based Swire Pacific which would also purchase
2% from CITIC and raise its own stake to 41.97%. The deal
leaves CITIC with a 2.98% Cathay holding. Transport sector
analysts were not surprised by the announcement and described
the deal as "inevitable." Given the recent history of
cooperation and profit-sharing between the two airlines and
cash-strapped CITIC Pacific's ongoing efforts to divest
non-core assets, this deal makes more sense than simply the
introduction of a third stakeholder. The deal is expected to
benefit all three companies but bring little benefit to
consumers. In the long-term, Air China may be interested in
controlling or merging with Cathay, but doing so might
complicate Cathay's ability to serve international routes and
would require Swire Pacific to give up one of its "most
profitable assets." END SUMMARY

"Inevitable Deal" Brings No Surprises
--------------


2. (C) Transport sector analysts were not surprised by the
announcement. Analyst Kelvin Lau of the Daiwa Institute of
Research H.K. Ltd., stated that Air China has expressed
interest in Cathay Pacific for several years, and the two
airlines have already forged profit-sharing and cargo joint
ventures. CITIC Pacific has been under tremendous pressure
to divest non-core assets after receiving a financial
bail-out package from the Chinese government last year.
"CITIC had to sell its stake in the airline and it just so
happens that Air China was ready and willing to buy," said
Corrine Png, J.P. Morgan's Asia Pacific Head of Equity
Research. For this deal to take place, majority stakeholder
Swire Pacific had to agree. Given the existing cooperation
between Air China and Cathay and pre-established legal
measures that guarantee Swire's continued management control
of the airline, analysts saw the deal as preferable to other
possible scenarios, such as a third party acquiring CITIC's
shares.

Everyone a Winner
--------------


3. (C) Analysts told us all three companies, Air China, CITIC
Pacific, and Swire Pacific would benefit. The Air
China-Cathay Pacific partnership has aimed at limiting
competition between the Beijing and Hong Kong hubs. With an
even closer alliance, both airlines win by further
complimenting existing networks and by sharing profits from
improving air transportation business cycles. Air China
benefits from access to Cathay's higher service standards and
business expertise, while Swire gains "brownie points from
the Chinese as the deal shows that Swire remains committed to
Hong Kong and the greater China region," said Damien Horth,
Transport Research Managing Director for UBS Investment Bank.
CITIC also benefits by easily divesting a non-core asset to
a "friendly" buyer at a premium of 11.84% above Cathay's
closing share price on August 14. Analysts see Cathay's new
ownership structure as having little impact on the consumer.
Pricing should remain unchanged, as Air China, Cathay
Pacific, and Dragon Air (Cathay's fully-owned subsidiary)
already dominate the profitable Beijing-Hong Kong route.

China Not Marrying Hong Kong's "Flag" Carrier, For Now
-------------- --------------


4. (C) Horth described Air China and Cathay's relationship
prior to this deal as "casually dating" but not yet
"engaged." He commented the recent deal "takes the
relationship one step closer to marriage but Swire retains
the final say," and further that "Swire would not easily
relinquish this highly profitable asset any time soon."
Although Horth believes an Air China-Cathay Pacific merger is
a very long-term possibility, he stated the different
operational cultures of the two companies, together with
local, regional and global regulatory challenges, all ensure
merger talks were not even on their medium-term agenda.
Although Hong Kong is a Special Administrative Region of
China, it retains autonomy over its air service agreements
and air traffic rights. As such, Cathay had to be
majority-owned by a national of the "country" (i.e., a Hong
Kong resident) or a Hong Kong-registered business to retain
"national" airline status and rights. Any move by Air China

for majority ownership would complicate Cathay's
international business.

MARUT