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RR RUEHCN RUEHGH
DE RUEHGH #0012/01 0111138
ZNR UUUUU ZZH
R 111138Z JAN 08
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 6594
INFO RUEHBJ/AMEMBASSY BEIJING 1635
RUEHSH/AMCONSUL SHENYANG 1051
RUEHGZ/AMCONSUL GUANGZHOU 1021
RUEHCN/AMCONSUL CHENGDU 1051
RUEHIN/AIT TAIPEI 0861
RUEHHK/AMCONSUL HONG KONG 1177
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RHEHAAA/NSC WASHINGTON DC
RUEHGP/AMEMBASSY SINGAPORE 0112
RUEHUL/AMEMBASSY SEOUL 0165
RUEHGH/AMCONSUL SHANGHAI 7123
RUEHKO/AMEMBASSY TOKYO 0258

UNCLAS SECTION 01 OF 04 SHANGHAI 000012 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EAP/CM, EEB AND E 
STATE FOR EEB/TRA/AN ROBL AND LIMAYE-DAVIS 
DOT FOR X1, X40 
DOT FOR ASSISTANT SECRETARY STEINBERG AND DAS MCDERMOTT 
TRANSPORTATION FOR OFFICE OF INT AVIATION - GLATZ 
 
E.O. 12958: N/A 
TAGS: EAIR ELTN ECPS ETRD EFIN CH
SUBJECT: CHINA EASTERN - SINGAPORE AIRLINES DEAL: BELLWETHER FOR 
CHANGE 
 
 
(U) This cable is sensitive but unclassified and for official 
use only.  Not for distribution outside of USG channels. 
 
¶1.  (SBU) Summary:  On January 8, China Eastern Airlines (CEA) 
shareholders rebuffed a deal that would have allowed Singapore 
International Airlines (SIA) to buy a strategic share of the 
company.  The move has sparked a wave of speculation regarding 
the meaning for CEA and the greater airline industry in China. 
The rejection occurred against the backdrop of maneuvering by 
CEA competitor China National Aviation Holding Corporation 
(CNAC) and new leadership at the General Administration of Civil 
Aviation of China (CAAC).  Shanghai-based financial industry 
analysts said the move was a mix of capital market forces and 
the hand of the Chinese Government moving the industry towards 
consolidation, a hallmark of the new CAAC leadership. 
Shanghai-based airline executives believe the rejection was 
simply a manipulation by the competitor, and noted that the 
original government approval of the deal is a signal that the 
Chinese Government is still on a path of liberalization.  The 
next move by CNAC and Beijing's reaction will be a good 
indicator of China's future direction on civil aviation reform. 
End Summary. 
 
A Doomed Deal? 
 
-------------- 
 
¶2.  (U) Financial industry analysts with whom we met were not 
surprised by the rejection of the SIA-CEA deal by CEA 
shareholders.  They noted that it was virtually impossible for 
the deal to be approved given that CNAC's and its supporters' 
(Cathay Pacific and Barclay Bank) combined votes surpassed the 
required one-thirds threshold to reject the deal.  Expectations 
that CNAC would put a higher price on the table also caused 
investors to bid up the price of CEA shares, far past what was 
viewed as a reasonable price when SIA made its initial offer. 
This new price then led many minority shareholders to believe 
SIA's offer was too low. 
 
¶3.  (U) CEA and SIA began negotiations on the deal in 2006 and 
won government approval for it in September 2007.  Under the 
deal, EAC would sell 1.75 billion shares (a 24 percent stake) to 
SIA and Temasek Holdings.  This would be the first time a 
foreign entity was allowed to purchase strategic ownership in a 
Chinese state-owned airline.  The purchase price of HKD 3.80 
(USD .49) was close to the share price at the time CEA share 
trading was suspended in late May 2007.  CEA shares virtually 
doubled in value following the announcement. 
 
The Sharks Circle 
 
----------------- 
 
¶4.  (U) Soon after the deal was approved, Cathay Pacific 
announced plans to team up with Air China to block it. (Note: 
Cathay Pacific and Air China, along with Dragon Air have 
connecting ownership ties, which already makes them one of the 
strongest airline groupings in Asia.  End note.)  Cathay Pacific 
dropped its bid on opposition from Beijing.  However, CNAC, the 
parent company of Air China, bought up CEA H shares, increasing 
its stake to 12.07 percent.  Meanwhile CEA launched an effort to 
convince shareholders that the agreed upon share price (almost 
half the current market value) was still a fair price. 
 
Add Some Political Intrigue 
 
--------------------------- 
 
¶5.  (U) On December 28, Air China and CNAC head Li Jiaxiang was 
promoted to Acting Minister of CAAC.  Quickly following the 
appointment, CNAC announced it would offer a counter-bid of no 
less than HKD5 (USD .64) if minority share holders rejected the 
CEA-SIA deal.  Cathay Pacific announced it would reconsider 
 
SHANGHAI 00000012  002 OF 004 
 
 
teaming up with CNAC in the counter-offer.  CEA issued a 
statement accusing CNAC of trying to mislead shareholders. 
 
Deal Rejected by a Wide Margin 
 
------------------------------ 
 
¶6.  (U) Spurred on by the higher bid from CNAC, more than 
seventy seven percent of the H share holders and ninety four 
percent of the A share holders voted against the deal on January 
¶8.  Immediately after the rejection, CEA Chairman Li Fenghua 
stressed the importance of cooperation with SIA, reiterating his 
wish to adopt SIA's top-notch management skills and operation 
efficiency.  Although CNAC is able to offer at least 40 percent 
higher per share and has more domestic resources to allocate to 
China Eastern, domestic carriers lack SIA's "software."  Li will 
"continue to communicate with the national government and CAAC 
to work out a better restructuring plan for China Eastern."  He 
publicly ruled out the possibility of merging with Air China. 
 
SIA - The Biggest Loser 
 
----------------------- 
 
¶7.  (SBU) The shareholder rejection negated two years of 
negotiation between CEA and SIA and will hamper SIA's plans to 
tap demand in China, where domestic flight demand is expected to 
increase fivefold by 2026, according to analysts of China's 
aviation market.  SIA's original plan was to utilize China 
Eastern's base in Shanghai, and enable it to challenge Air China 
and Cathay Pacific inside China.  According to media reports, 
SIA CEO Chew Choon Seng said on Dec 12 that the company will not 
raise its offer as "nothing is a must-have." 
 
CEA Shareholders -- The Biggest Winners 
 
--------------------------------------- 
 
¶8.  (SBU) In discussions with ConGen, civil aviation market 
analysts opined that a strategic alliance with Air China would 
be more beneficial to CEA by enabling it to expand market share 
outside of Shanghai.  This belief has lead many investors to 
believe a rejection of the CEA-SIA deal would drive the stock 
price even higher.  One analyst said "the biggest beneficiary of 
the bid rejection, however, will be the shareholders since they 
receive a counter-bid that is thirty to fifty percent higher." 
Other analysts noted that shareholders vetoed the deal because 
investors simply pay the most attention to the offer price. 
However, on news of the failed bid, shares of CEA immediately 
dropped 1.75 percent. 
 
What About the Service? 
 
----------------------- 
 
¶9.  (SBU) In a recent meeting with Econoff, CEA's management 
said the company's major competitive strategy is to compete by 
providing better service, rather than adjusting fares.  CEA's 
goal on international flights is to improve its overall 
management skill and efficiency, which is why the company 
decided to partner with SIA in the first place.  CEA needed an 
"infusion" of customer service skills to compete 
internationally.  CEA management also hoped the partnership with 
SIA would also bring better customer service skills and 
management to their domestic flights as well. 
 
¶10.  (SBU) Besides looking to a deal with SIA, CEA outlined 
other measures it has taken to increase its customer service 
orientation.  For example, CEA views the recent capacity sharing 
program with other carriers for the Shanghai-Beijing route as 
positive for the industry.  This program was designed to offset 
negative effects from flight delays as consumers are free to get 
on the next available flight in this program.  It also 
 
SHANGHAI 00000012  003 OF 004 
 
 
alleviates many discounted tickets since all flights in the 
program must set their fares at similar rates and charge the 
same service fees.  CEA operates 14 flights each day between 
Shanghai and Beijing. 
 
Shanghai Analysts See Consolidation in the Future 
 
--------------------------------------------- ---- 
 
¶11.  (SBU) In conversations with Congen, Shanghai financial 
industry analysts said they believe the Chinese Government was 
partially behind the rejection.  They expect CEA will eventually 
merge with Air China to create a giant carrier, with 60 percent 
market share in Beijing and 50 percent market share in Shanghai. 
 They opined that Air China could bring in a much better balance 
sheet than SIA.  If they merge, their combined first year 
revenue could be as large as USD 500 to 700 million, compared 
with the USD 150 - 200 million under an SIA merger. 
 
Other Shanghai-Based Airlines Say Liberalization on Course 
 
--------------------------------------------- ------------- 
 
¶12.  (SBU) The Contract and Planning Department Manager from 
Shanghai Airlines asserted that the rejection of the deal will 
negatively impact CEA, given the twenty-four percent stake 
purchase from SIA would have immediately lifted the book value, 
debt ratio and cash flow of CEA.  Even though CNAC announced a 
higher counter-bid, he noted this offer is still not officially 
proposed through the China Securities Regulatory Commission 
(CSRC).  He believes this is only a strategy from CNAC to 
influence minority shareholders to veto the SIA deal.  The 
failure of the deal, however, would likely benefit Shanghai 
Airlines, since its major competitor in the Shanghai hub would 
not get bigger (Note: CEA has 41.1 percent market share in 
Shanghai versus Shanghai Airlines' 18.7 percent. End note).  He 
was also skeptical that Air China could actually afford to 
acquire CEA.  He doubted the Chinese Government intended an 
industry restructuring to combine Air China with China Eastern 
and China Southern, despite CAAC President Li Jiaxing's public 
support for consolidating the industry. 
 
China Still Welcomes Foreign Investment in Airlines 
 
--------------------------------------------- ------ 
 
¶13.  (SBU) A top executive from Juneyao Airline, one of China's 
first fully private airlines, concurred that there would likely 
not be an industry restructuring resulting in a mega Chinese 
airline.  The rejection was a result of "insider" maneuvering 
and some capital market forces that had driven the share prices 
beyond that of the initial agreement.   He emphasized the move 
was not a result of government pushing for consolidation, or a 
backtracking on the path of liberalization and deregulation. 
Despite CAAC Acting Minister Li's arguments for consolidation, 
consensus in the government is still firmly in favor of 
improving Chinese airlines through allowing greater competition, 
citing the long deliberation process that resulted in approval 
of SIA's investment in CEA in the first place. 
 
¶14. (SBU) The Juneyao executive maintained the Chinese 
Government still welcomes strategic investors that can increase 
competitiveness and the quality of Chinese airlines.  Some 
government moves were misconstrued by outsiders and so they 
believe the government is moving in the opposite direction.  He 
cited a 2007 move by the Chinese Government putting a moratorium 
on licenses issued for new private airlines.  The stop was not a 
move by government to limit private competition but a direct 
result of bottlenecks created by a shortage of pilots and 
airport and air corridor space.   China is expected to 
experience a shortage of 30,000 pilots in the next 3 to 5 years, 
and the demand created by new airlines had taxed the available 
pilots to the limit.  It had become a safety issue because of 
 
SHANGHAI 00000012  004 OF 004 
 
 
"overworked" pilots. 
 
¶15.  (SBU) The Juneyao executive said the Chinese Government 
will allow CEA's investors to make the final decision, but the 
Government's ultimate goal is still to bring foreign expertise 
and capital into China's airlines.  He was quick to point out 
that the SIA deal was approved at the State Council level, not 
only CAAC.  And, any potential deal with CNAC would also likely 
require the State Council's approval.  Hence, CAAC Acting 
Minister Li's push for consolidation would be tempered.  He also 
noted another reason that a deal with Air China is highly 
unlikely.  Citing a personal relationship with the CEO of China 
Eastern Group, the holding company of CEA, he said the CEO is 
very much against any deal with Air China and would work to stop 
any such deal.  As for impact on his own company, he said the 
result had no impact because Juneyao does not compete directly 
with CEA. 
 
Background on CEA - One of China's Top Three Air Carriers 
 
--------------------------------------------- ------------ 
 
¶16.  (U) Established in 1997, CEA is one of the top three air 
carriers in China (the other two are Air China and China 
Southern).  CEA is headquartered in Shanghai.  Currently CEA 
operates a total of 423 routes, of which 299 are domestic 
routes, 19 are Hong Kong routes and 105 are international 
routes.  It operates approximately 5,650 scheduled flights per 
week, serving a total of 136 foreign and domestic cities.  The 
company's main aircrafts are Airbus A340, A 330, and A321 and 
Boeing 737 and 777.  Among them, Boeing 737 and 777 are more 
focused on its domestic small cities routes while Airbus A340 is 
used for international flights.  CEA also operates 5 Canadian 
Regional Jet aircraft and 5 Embraer Regional Jet aircraft to 
serve its Wuhan and Nanjing routes.  CEA's main revenue (90 
percent) is generated by passenger service and the remaining 10 
percent from its cargo business. 
 
CEA's U.S. Routes 
 
----------------- 
 
¶17.  (U) CEA's predecessor entity started Shanghai-Los Angeles 
service in 1991.  That route was the airline's first route to a 
U.S. destination.  Currently CEA provides daily flights on this 
route and it is one of CEA's most profitable routes.  In 2006, 
CEA launched the world's first direct flight between Shanghai 
and New York.  Presently the passenger load factor (PLF) is over 
80 percent for this route.  However, the first class and 
business class customer load on this route is still below the 
company's expectation.  Hence, they plan to replace A340s on 
this route with Boeing 787s to reduce passenger capacity and 
increase its PLF.  CEA also attributes its weak high-end 
passenger load on its NY route to an unsuccessful marketing 
strategy and the company will increase its marketing expense for 
this route in the future.  Overall, CEA's major international 
markets are the United States and France. 
 
Comment 
 
------- 
 
¶18.  (SBU) Comment:  Most agree the CEA-SIA deal rejection was 
largely due to the high counter-bid price from CNAC and the 
resulting speculative current share price.  It is also clear 
CNAC, as a partner of Cathay Pacific and a competitor of CEA, 
had a strong incentive to scuttle the deal.  However, it remains 
unclear if and to what extent the government was involved and 
whether CNAC's move was merely a way to slow the competition, or 
whether it truly intends to work for consolidation of the major 
Chinese airlines.  How Beijing reacts to CNAC's next move will 
provide light on how the Central Government will push civil 
aviation reform in the near term. 
KJARRETT