Aviation's Future and the Battle for China Eastern

By staff reporters Chen Huiying, Li Qiyan, and Yu Ning in Beijing; 

Ji Minhua in Guangzhou; and Xu Ke in Hong Kong

The weekend of September 21-24 passed slowly for anxious investors who follow mainland Chinese companies listed on Hong Kong's Hang Seng H-share Index. A half-hour before the market closed that Friday afternoon, trading in shares of Cathay Pacific Airways Ltd. (SEHK: 0293) was suspended. Investors were told "a proposed deal" would be announced.

Coupled with that day's major increases in share prices for Air China (SEHK: 0753, SSE: 601111) and China Eastern Airlines (SEHK: 0670, SSE: 600115), a rumor quickly spread that Cathay would announce a tie-up with Air China to buy a stake in China Eastern. The move would supposedly block efforts by Singapore Airlines and Temasek Holdings Pte Ltd. – an investment arm of the Singapore government -- to become strategic investors in China Eastern.

At first, analysts familiar with the civil aviation sector in China concluded that this was a hostile takeover bid. Yet few thought it possible. It was hard to believe that two, major Chinese state-owned enterprises (SOEs) would join in the kind of takeover raid typical in a capitalist marketplace. These SOEs shared a common financier – the State-Owned Assets Supervision and Administration Commission (SASAC), which operates under China's cabinet, the State Council. The rumors were forecasting an ugly contest between two subsidiaries of the same parent.

As events unfolded, all doubts were dispelled. Trading in Air China stock was suspended, signaling the start of a preemptive buyout battle. H-share market investors were gripped by that peculiar mix of emotions often seen on the eve of a major conflict – tension and excitement, coupled with unease about what lay ahead.

China Eastern's share price had been rising steadily. It closed before that fateful weekend at HK＄ 9.72, up 12 percent on the day and 50 percent since the start of the week. Shares in Cathay also rose on  Friday by 11 percent, closing at HK＄ 22.70.

On the Shanghai exchange, China Eastern's A-shares opened higher at 23.32 yuan on the following Monday morning. Its H-shares likewise climbed, opening at HK＄ 10.40.

Both investors and the media waited for a Monday announcement from Cathay, although there was no sign of it by noon. All phone lines were engaged at Cathay's public relations department. A reporter finally got through at 2 p.m., only to be told that Cathay would not hold a press conference that afternoon and that no one knew when an announcement would be made.

When trading closed for the day, Cathay's PR office was still unable to say when an announcement would be made.

Apparently, the situation had quietly changed. Just as the battle was about to begin – 90 minutes before Monday trading closed and 72 hours after the trading in Cathay shares was suspended – China Eastern's H-shares began falling sharply. The price tumbled 9 percent in 30 minutes to HK＄ 8.91 and closed at HK＄ 8.70, down 10.49 percent. In Shanghai, China Eastern's A-shares closed at 21.94 yuan, down 3.81 percent.

Cathay eventually announced Monday night that trading in its shares would resume. But in a surprise twist, the airline also announced that it "would no longer be continuing implementation" of a proposed takeover plan. 

This rare buyout battle between two SOEs had foundered at the last minute. And the only party with the power to call off the deal at such a critical juncture was the financier -- SASAC. A source close to the matter confirmed to that SASAC had notified Air China that it did not support the planned deal.

Careful market observers noted differences in the wording of statements from Cathay and Air China. The latter admitted that its parent company, China National Aviation Holding, had previously worked with Cathay to prepare a plan to buy a stake in China Eastern "but that, as things currently stood, would not be involved in any preparations, talks, expressions of intent or agreements in regard to such a deal during the coming three months." The ambiguity invited speculation.

China Eastern sources raised doubts about the meaning of the Air China announcement. A senior executive said that Air China was signaling to the market that it would present an even more attractive buyout offer and an even higher price. "The Air China statement is bound to have an effect on the market and will mean the next annual meeting will be something of a contest," the China Eastern executive said.

"Without the hostile intervention of a third party, the (plans of the present board) would certainly be supported by public investors at the next shareholders meeting," the executive said. "If there is such hostile interference, then we'll have to see what action, if any, the government chooses to take."

This tallied with what was told by a number of people at China Eastern -- that the airline had to speed up the completion of deals to attract investors, making sure all transactions were completed by the end of this year, or no later than early 2008. Delays were unacceptable.

The proposed deal with Singapore Airlines and Temasek made public by China Eastern on September 2 was only a framework agreement and was not legally binding. China Eastern and Singapore Airlines are currently increasing efforts to iron out details of an agreement. Once signed, the contract would have to be approved by China Eastern's board and then by shareholders at a special meeting.

"This thing is a long way from being over," according to one senior manager at China Eastern who spoke to . Air China's announcement that "it would not be making any moves for three months" was "only to have the opposite effect, which meant to influence smaller investors in their vote," he said.

"I hope they stop what they're doing," the manager said. "But if they don't stop, we'll be ready for them."

How will this titanic struggle unfold and answer weltering questions about the future of China's airline industry?

Air China, China Eastern strategize

Market watchers have found a wealth of interest in this unusual deal, including the principals involved and the game's details.

The two sides facing off are alliances with major, state-owned aviation companies and foreign strategic backers. The move was timed for a crucial moment when, although the companies supported the plan to bring in strategic investors, shareholders had yet to give their approval. Still more cunningly designed was a competitive price offer for shares aimed at encouraging small investors to reject the takeover plan of a competitor when it came up for a vote. Even the staggered timing of trading suspensions by the two, allied airlines and the discrepancies in the wording of their announcements were likely part of the plan.

Clearly, the attempt at a preemptive buyout by Air China and Cathay was sparked by China Eastern's plans to bring in strategic investors. But this pair of potential raiders had cooperated on other projects. In June 2006, Air China and Cathay agreed to swap stocks and began working together to set up an air cargo company in Shanghai. Afterward, their collaboration gathered pace.

China Eastern first started thinking about finding strategic investors in 2000, although there were no formal moves to initiate the action. At the time, the airline was finalizing takeovers of the domestic carriers Yunnan and Northwestern. China Eastern made its first contact with Singapore Airlines – which had been extremely keen to enter the Chinese market – in 2005, but no real progress was made.

The deal-making peaked when China Eastern signed the framework agreement with Singapore Airlines and Temasek. It provided for issuing more than 2.98 billion H-shares in China Eastern priced at HK＄ 3.80 each. Some 1.88 billion shares would be sold to the two Singapore investors, giving them a combined 24 percent stake in the Chinese carrier. Another 1.1 billion H-shares were to be sold to the parent company China Eastern Airlines Group, allowing it to maintain a controlling 51 percent. This would raise HK＄ 7.16 billion from the Singaporeans and HK＄ 4.182 billion from the parent.

learned that Air China submitted a report to SASAC early this year that set out the company's intent to buy out and restructure China Eastern. Air China received no response. In April and May, amid talks between China Eastern and the Singapore investors, Air China's parent China National Aviation Holding Company had started increasing its holdings of China Eastern H-shares, buying stock on secondary markets through its wholly owned subsidiary in Hong Kong, Air China (Group) Ltd.

By April 20, companies associated with Air China held more than 5 percent of China Eastern's H-shares, spending only HK＄ 2.31 per share. Following market regulations, the size of this holding was listed on the Hong Kong exchange's Web site.

Air China's drive to increase China Eastern holdings continued without letup. Its associated companies were still buying shares at HK＄ 6.50 on September 4, raising its H-share stake to 11 percent. One analyst told that this purchase of shares at the high price of HK＄ 6.50 had alerted them to Air China's intention to head off a Singapore Airlines buyout through the market. Taking shares in China Eastern at such a premium could not be explained away as a "financial investment."

"We were aware of Air China's increase in holdings all along," admitted one source close to China Eastern. "They were looking to, on the one hand, use the markets to scare off Singapore Airlines from their decision to make a strategic investment and, at the same time, raise the price of China Eastern H-shares to a level that would increase the cost of any investment by the Singaporeans.

"The entry of Cathay Pacific into the picture did come as a surprise," the source added. "When they suspended trading, we had a strong feeling that there was a potential buyout battle in the offing."

Although details were as yet unknown, the market was already getting its first sense of the nature of Air China's plan – using market intervention to influence or even alter China Eastern's plans to bring in strategic investment and, beyond that, to seek an opportunity to buy China Eastern altogether. These preliminary maneuvers for a buyout war sent China Eastern and Air China shares rocketing upward.

In what could have been no coincidence, Air China President Li Jiaxiang made no secret of his hopes to buy China Eastern on September 21 -- the same day that Cathay suspended trading. Li was responding to questions about restructuring in the civil aviation sector during the launch of his new book, Dadao Xiangtong (All Means Are the Same).

"As we integrate our civil aviation resources, we do indeed face the question of forming a force powerful enough to combat outside competition," Li said. "If you plan to do anything, it has to be to occupy the strategic high ground, and you do that by first taking it over."

Air China's takeover strategy

learned that the core of the Air China-Cathay Pacific strategy is a proposed takeover to be carried out in two stages: first, a preemptive bid to head off the opposition, and then a move to replace its rival as a new buyer. The key to success for such a strategy is its ability to win over a sufficient number of smaller investors, having them vote down the Singapore Airlines investment plan, and then introducing a new China Eastern buyout plan.

Air China's earlier purchases of H-shares clued market watchers to their intentions. One Citigroup report stated, "Air China and Cathay Pacific are likely to use their shareholding to head off any attempts by China Eastern to bring in new strategic investment."

China Eastern Group currently holds 59.7 percent of China Eastern shares, all of which are A-shares. The remaining stock includes 8.1 percent of floating A-shares and 32.2 percent floating H-shares. Regulations say that, as an intended buyer of new China Eastern issues, China Eastern Group must abstain from voting on the deal, meaning that only holders of the 40.3 percent of floating stock would have the right to vote on a decision at a general meeting.

Before issuing new H-shares, China Eastern needs approval from holders of the same stock type and three, favorable votes with two-thirds majorities. The deal will go through only if it is approved by two-thirds of minority A-share holders, two-thirds of minority H-share holders, and two-thirds of the combined minority holders of both A-shares and H-shares. In contrast, the best way for Air China to defeat plans for a new issue is to convince more than one-third of minority H-share holders to vote against the plan.

It's unclear whether Cathay holds any H-shares in China Eastern to supplement the 11 percent controlled by its ally Air China. Regardless, Air China almost certainly will have to win over other minority investors if it wants to head off the Singapore deal.

The Air China alliance is relying on a new buyout proposal with a more attractive price as well as Cathay's influence on the Hong Kong market.

One source told that the Air China-Cathay partnership was willing to meet – and better -- any offer made by Singapore Airlines-Temasek in terms of price and conditions. Air China-Cathay would be certain to offer more than the HK＄ 3.80 per H-share proposed by the Singaporeans, the source said.

When trading in China Eastern's H-shares resumed September 3, following a pause for the Singapore tie-up announcement, the stock price rose sharply. By the time Cathay's trading was suspended three weeks later, China Eastern's shares had broken the HK＄ 9 barrier – a level reached after a climb that paralleled months of investment talks. Now, the relatively low price offered by the Singaporeans was bound to generate opposition to the deal among smaller investors, giving Air China the chance it wanted.

Price had been a key issue during talks between China Eastern and Singapore Airlines, which later brought Temasek into the deal in an effort to keep a lid on its own costs. Any price issues raised in a buyout battle would further pressure the Singaporeans.

However, some Hong Kong markets specialists were of the opinion that, while a preemptive strike might be possible, there was little likelihood of an alternate takeover bid. Since China Eastern and Singapore Airlines had drafted a sale agreement, any over-valuation would only serve to create more investment for the airline, rather than transfer directly into the hands of smaller shareholders. This would mean that an investors' basis for consideration would revolve around the best offer for China Eastern. Knowing the airline opposed intervention by Air China and Cathay, the higher share price would not necessarily influence shareholders to vote against the original deal. 

"This was not a complete tender offer, so there would be no chance for two, alternative proposals to be put before a general shareholders meeting," said one industry insider. "Since it was a previously signed deal, the intentions of the majority shareholders would be decisive and, ultimately, there would only be one proposal for the minority shareholders to vote for.

"Minority shareholders knew full well that if they rejected the deal, it would mean China Eastern had failed to attract investment, and the biggest losers would be the listed company and the shareholders," the insider said.

Playing the political card

Of course, the market did not decide the outcome of this battle. Both sides were well aware that, given the realities of modern China and the ownership structures of the three airlines involved, the attitudes of regulatory authorities played a key role.

A China Eastern employee involved in efforts to attract investment told that almost every deal involving a takeover or merger in China requires government as well as investor relations. This has been especially true in China Eastern's case.

"We needed to let the government know about this, and also let shareholders know," the employee said. "More important was to make the government understand the best kind of structure for the deal, from the standpoint of the sector's overall development and consumer interests, and what kind of structure is right for the industry."

Yet it appeared Air China's actions in this case broke with these old rules of  "doing business with Chinese characteristics."

A general view among market watchers was that Air China had taken the lead in collaborating with Cathay. Sources close to Cathay said the airline is careful not to oppose anything agreed upon by the Chinese government because its business depends heavily on the mainland economy. Cathay was happy to work closely with Air China not only to develop a Shanghai cargo center but also because it trusted the Chinese airline's political backing.

It was a shock for many market players that the Air China-Cathay Pacific plan to take over China Eastern was shot down before take-off. A general view had been, right from the first increases in holdings until Cathay announced resumed trading for its shares, that Air China had already smoothed the way for a deal with the government, or had at very least obtained tacit agreements from senior officials at supervisory agencies, allowing them to initially proceed with a deal through the market.

"On one side, it put psychological pressure on China Eastern and Singapore Airlines by threatening to make them lose a vote from shareholders," said an investment banking source. "On the other side, Air China raised the overall cost for a Singapore Airlines  acquisition."

Yet Air China's decision to abandon the game at the very last minute was a complete surprise. What at first had seemed like a creative move was being called "bold and immature." In the words of one insider, "The way things normally work, if you're a senior manager at a SOE, you're not going to go and interfere in a deal that's already been approved by SASAC."

Yet there were also several market players with different interpretations of Air China's move. They viewed it as an attempt to promote industry restructuring through the market, using the power of the market to make China Eastern -- and even SASAC itself -- reconsider the decision to corral Singapore Airlines as a strategic investor.

Air China, with its long-held dream to become a "super carrier," missed a chance to use the momentum achieved by sustained profitability to buy loss-making China Eastern. The failure left few prospects for another chance any time soon. For China Eastern, mired in losses but working hard to save itself, an improved bottom line was only in the cards if a deal with Singapore Airlines could be settled sooner rather than later, improving business operations and reviving hopes for an improved future.

Air China has two arguments available if it hopes to persuade regulatory authorities to overturn the already approved deal between China Eastern and Singapore Airlines. One would be to make an issue of Singapore Airlines' status as a foreign carrier and play up the need to develop domestic business. The other would be to emphasize that a realignment of the current balance of forces between the three, main domestic airlines would improve their competitiveness in international markets.

Clearly, Air China has been much less persuasive than China Eastern and Singapore Airlines. Air China was worried that a delay would only add to its troubles and that, once the competing deal was done, there would be no turning back. This view, combined with concern that share prices would rise too high, forced the carrier to act.

The executive vice president of GCW Consulting, Wang Xianping, noted that although it was something of "a loss of face" for Air China to abandon its planned move at the last minute, the carrier's overall direction was smart. "Because if you don't show a strong hand first, tomorrow you may well find yourself in the same situation as China Eastern, vulnerable to takeover," Wang said. "They had to make the move when the opportunity arose."

But the key to any move is prior approval from the government. And insiders at China Eastern said its investment plan had already been approved, not only by SASAC but also by authorities at even higher levels. "If Air China were able to join Cathay to buy China Eastern, that would mean rejecting a decision that had already been made by SASAC," said one China Eastern board member. "We're just waiting for them (Air China) to make a wrong move."

The rashness of Air China's move can be attributed to a large extent to ambiguous signals from SASAC concerning industry restructuring. China's civil aviation sector has been abuzz since last year with talk of the three main airlines being reduced to two or just one. Li Rongrong, chairman of SASAC, has made a number of public statements that included a call for SOEs to make themselves "big and strong", although he offered no final plans.

Damien Horth, an airline analyst at UBS, told , "Air China has a strong leader Li Jiaxiang, and he brings great enthusiasm both to Air China and to the China civil aviation sector as a whole. The thinking behind Air China's attempt to restructure through buyout is very clear. But political factors play a large part in the way the civil aviation sector is shaped in China."

Professor Zheng Xingwu of the Civil Aviation University of China, however, thinks issues of monopoly fall outside the area of concern for SASAC in its role as a financier representative. Zheng thinks that, in a situation where market discipline is a major factor in running operations, mergers and acquisitions among air cargo operators can only improve the efficiency of the industry as a whole and invigorate the market. He sees no danger in allowing a small number of airlines to monopolize the market. China's three main airlines currently control more than 70 percent of the domestic market, but in the air freight sector -- as in other markets -- the emergence of a single, dominating enterprise is not something to fear, he said. The key is how that enterprise achieves dominance, and whether it abuses its position to influence normal market operations, Zheng said.

Outlook for industry restructuring 

Air China's bold move ultimately came to nothing, although it has profound implications over the long-term for competition in the civil aviation sector.

Two leading predictions for industry reorganization are currently being floated on the market. One is that the three main airlines will merge into a single carrier. A second scenario is that two airlines will merge, leaving two players to dominate the market. Since China Eastern is currently the weakest of the three, yet has its base in the highly desirable Shanghai market, it is seen as the best target for a buyout.

China's air freight industry is another issue. Before 2002, investors would have ranked the sector's main carriers with China Eastern on top, followed by China Southern and Air China. An industry restructuring that kicked off in March 2002 saw a gradual reversal. Now, Air China leads the market and China Eastern is last.

What sparked this radical shift? As industry insiders see it, the first place to look for an answer is the disparity in the way resources were allocated during the industry's restructuring: Air China was given the best resources.

As the first to complete restructuring and integration, Air China saw immediate benefits in terms of business within the industry and among travelers. At home, its subsidiaries China Southwest Airlines took control of the market in the country's west. A buyout of Shandong Airlines added routes in the east. Eventually, Air China became the airline with the strongest presence in major destinations and on high-quality routes. 

The company also garnered the highest share of the international market among domestic carriers. Air China was very active in money markets, successfully brokering deals to exchange shares with Cathay and Dragon Air. In particular, its strategy to create hubs in Beijing and Hong Kong after the share swaps went a long way to cementing Air China's position as China's leading domestic airline.

Company president Li freely admits that Air China's recent success is in the first instance a product of the reorganization shaped by his predecessors. "It was only after we got a head start that Air China gained the ability to proactively institute an even more thorough restructuring of our business resources and corporate culture, and to reform our internal management structure," he said. "It also bought us the time we needed to implement our strategy."

By contrast, China Southern, which was the first mainland airline to go public, saw competitiveness in its core business fall sharply following its 2002 restructuring. The company had been relatively cautious over the years in developing international routes. While China Eastern and Air China were engaged in fierce competition for the best international routes, China Southern displayed aloofness toward the fight. Domestically, although well known for its broad network, China Southern found itself facing stiff competition on all the routes where it previously had been market leader. It began to see steady retreats in value for some, once-profitable routes.

Today, the gap in business operations between the three leading airlines has widened. Mid-year reports for 2007 showed Air China had the best earnings, with a gross profit ratio exceeding 15.7 percent. Revenues from international routes reached 10.9 billion yuan, up 35 percent from 2006, to account for 49 percent of main business earnings. China Southern's operating revenue from international flights, accounting for 20 percent of its main business, rose 8.4 percent to just over 5 billion yuan. China Eastern earned 8.54 billion yuan from international routes, up 27 percent and accounting for 43 percent of business earnings.

After competing for a number of years, China's main airlines saw a shift in their fortunes. Air China, once the worst performer and with the worst service, was now the top performer. China Eastern, despite its lock on Shanghai, the richest transport hub, was finding its geographical advantage offset by problems with restructuring, which included the Yunnan and Northwestern buyouts. A failure to stem internal losses also brought a severe cut in competitiveness. At the same time, other airlines were encroaching on China Eastern's territory, forcing the airline into a fight to protect its Shanghai base.

China Eastern rides to its own rescue

As China Eastern struggled with Yunnan and Northwestern, the already restructured Air China began using every means at its disposal to steal market share in Shanghai away from its competitor.

China Eastern was forced to defend its home market while at the same time completing its internal restructuring. In 2004, China Eastern settled on a strategy of nationwide mobilization to protect its Shanghai presence, reassigning air and ground crews from 14 subsidiaries around the country to the hub, even while surrendering other markets. But an air crash in Baotou, as well as other safety incidents, forced China Eastern to abandon this approach. The airline was losing its share of the Shanghai market and the advantages that its two new acquisitions once held. 

In 2003, the Civil Aviation Administration of China (CAAC) and the Shanghai government worked together on a strategy to make the country's largest metropolis a major transport hub. They planned for the project to be basically accomplished by 2010. A general view in the industry was that this was an ideal opportunity for China Eastern to change its route network strategy. But, once again, the airline missed its chance.

A project manager who was formerly part of the team tasked with establishing Shanghai as a transport hub told that China Eastern's strategy at the time was marked by prevarication and a failure to settle on a single objective. The construction of the airline's own hub was cited as an example of the problems. After numerous plan changes, China Eastern eventually abandoned a proposal to build a new terminal at Shanghai Pudong International Airport, and instead set up shop inside the airport's Terminal One.

"China Eastern got in its own way on this. The outcome was that its original plan to have China's biggest passenger hub with 28 boarding ramps was just not possible, because it couldn't organize the necessities," the project manager said. In the manager's view, China Eastern's inability to settle on a strategy came down to problems with internal management. At this critical point in company history, while creating a Shanghai hub, China Eastern lacked the decisiveness needed to make the transition to a network structure. "We won't get another chance as good as that for years," the manager lamented.

Constant shuffling and even sackings among senior managers are also cited by industry observers as internal factors contributing to the fall of China Eastern. Numerous changes in the make-up of the airlines senior management team have occurred over the past decade, affecting not only the company's ability to maintain a consistent strategy but also contributing to factionalism that seriously hurt competitiveness. In the second half of 2006, a string of stories emerged from the company about scandals and business losses. Wu Jiuhong, then deputy general manager, and Tong Guozhao, who had been head of the cargo division, were handed over to supervisory authorities for alleged "breach of discipline."

In 2006, as Air China posted profits of 3.5 billion yuan and China Southern had moved into profitability, China Eastern reported a loss of as much as 2.8 billion yuan. Although a company spokesperson blamed the loss on the costs of "dealing with our older aircraft," it was impossible to conceal its operational and financial problems. Annual reports for 2006 showed that China Eastern's indebtedness reached 93 percent, while Air China's stood at around 60 percent. Luo Zhuping, board secretary at China Eastern, stated frankly that the ongoing high cost of servicing debt and level of general indebtedness was forcing the company into a situation that left no alternative but to seek out investment.

With morale low at China Eastern, the industry was rife with rumors that second restructuring of the sector was imminent. There were several options offered, including media reports that a document on the major tasks for the state-owned sector in 2007 included SASAC proposals for further restructuring of the civil aviation sector to create a market with two major airlines and a number of small- and medium-sized carriers to increase competition. This would be accompanied by restructuring of the three main airlines and the regional carriers, the stories said. The reports led to speculation on the market of a merger of the three main airlines or the "two plus many" model that would see a merger of two dominant players. In the latter scenario, struggling China Eastern was deemed the likely candidate for takeover.

These rumors didn't quell China Eastern's hunger to compete. So to save itself, the company began working to bring in new foreign investment. That led to the deal with Singapore Airlines.

In late September, China Eastern's Luo told that the investment deal represented more than just a sale of shares, but a wide-ranging strategic collaboration as well. While a final agreement has yet to be signed, progress has been made and the two carriers are cooperating. "Shanghai makes a great transport center, and we want to turn it into a world-class air transport hub," Luo said. "All we lack is a really good airline. Singapore Airlines is the best-run civil aviation operator in the world. The rise of China Eastern is now just a matter of time."

Dreams of creating China's 'super carrier'

If China Eastern is able to complete its tie-up with Singapore Airlines, Air China will have missed its best chance to buy China Eastern. This is not an outcome Air China, with its persistent ambition to become China's "super carrier," wants to see.

Li, in his recent book, argued for Air China's future as a "super carrier." He wrote, "If each of the three major domestic carriers brings in an international airline as a shareholder, it will be even harder to achieve strategic cooperation in the China civil aviation sector, and competition will accelerate. The big, international "super carriers" will cut themselves bigger slices of the China aviation cake, leaving nothing for anyone else.

"As we reorganize our civil aviation resources, we do indeed face the question of forming a force powerful enough to combat outside competition."

Speaking at the book launch, Li said that although China is a major aviation market, the nation's aviation industry has yet to become a major player. "The trend now in international aviation is for fewer companies, not more," he said.

In his book, Li advocated Air China as an "international super carrier" through restructuring, mergers and industry reorganization. His offered a vision of a "Greater China Aviation Alliance" that's forged, when the time is right, with Macao Airlines and Taiwanese carriers. The alliance would be built on the advantages of the cross-stakes relationship between Air China and Cathay.

In the eyes of experts, this ambitious plan is very likely to fall victim to the various fears different players have concerning the civil aviation sector. Zhang Wenkui, vice director of the Enterprise Research Institute at the State Council's Development Research Center, thinks that, since it took the reforms of the 1990s to finally bring competition to the China aviation industry, a return to the old monopoly structure should not be allowed without careful forethought.

UBS' Horth said that, although Li is an enthusiastic leader, what's best for Air China is not necessarily best for China. He thinks the final decision about Air China's ambitions must rest with government supervisors.

has learned that Air China asked China International Capital Corp. (CICC), an investment bank, to draft a plan for a China Eastern buyout. The plan was submitted to SASAC in April. China Southern also presented two proposals to SASAC -- one to buy both Air China and China Eastern, the other involving a merger with only Air China. Although SASAC has not publicly commented, authoritative sources told the government does not want to rush into an integration of civil aviation.

At this stage, if authorities continue supporting the collaboration of China Eastern and Singapore Airlines, Air China's ambitions will remain frozen even after its previously announced, three-month pause. The collaboration would strengthen China Eastern's place among the big three airlines. It would also mean that, since Air China already has a strategic partner in Cathay, China Southern would consider welcoming Air France as an international strategic investor. As the balance of forces between the three steadies, the industry's division into "three kingdoms" will become further entrenched.

Key role for government supervisors

Will China's aviation sector, under pressure from shifting capital and an expansion of domestic leaders, reunite 20 years after its breakup, launching an era of super carriers? What will struggles around this issue mean for China's skies? Now anything seems possible for realigning civil aviation, but nothing is certain.

Professor Zheng thinks the issue is not whether a super carrier operates in China, but how such as airline might be created. If it happens through the course of normal market competition, the state merely has to build an appropriate regulatory framework to guard against monopolistic practices. But Zheng foresees problems for the healthy growth of the airline business if an airline giant is created by administrative means – including government-led industry restructuring or integration – rather than through a market-led reallocation of resources.

The key to any shift in civil aviation's structure lies not in whether the three main players are combined, or whether one is bought by another, nor in the amount of foreign investment that comes in, but in the creation of an effective mechanism for competition. If this is not in place, the sector will not offset weakness at China Eastern, regardless of the quality of management at Singapore Airlines. And no matter how big Air China becomes, it will never become one of the three, most profitable international airlines.

China's civil aviation sector is entering a period of unprecedented growth. The strength of the national economy has helped the industry expand. The sector's 15 percent growth in air traffic was the second highest in the world last year, trailing only India's increase of more than 30 percent. And after years of rapid growth, the size of China's aviation sector is now second only to the United States.

Yet profitability remains low. UBS research on global airlines placed China's three largest carriers on a list of 10 with the lowest pre-tax profits. China Eastern's profits were lowest and Air China's highest among the Chinese carriers. Financial performances for all three were below industry average. The UBS report was not upbeat about the carriers' stock values, since each "traditionally has been able to turn only a small part of income into profit."

Why such poor profitability? Some blame excess competition. But in reality, the benefits of competition are plain to see. Ten years of competition brought vast improvements to management and service quality in the aviation sector. Competition is the only reason why airlines far outperform the as-yet unmarketized road transportation industry.

Five years on from its last round of restructuring, the impetus for the next reordering of China's aviation industry is apparent. The market has shown that the previous administration-led restructuring was ineffective. In the aftermath of the battle to buy China Eastern, questions linger about the best role for supervisory authorities, and how that role should be played.

Intern reporter Gao Jian contributed to this article.