Hong Kong-listed Swire Pacific may accept Air China shares in return for its 45.73 per cent stake in Cathay, a move that would make it the single largest shareholder in the mainland carrier and place its executives at the core of the new group's operations, according to informed sources in the affected companies.

'A deal is very close to being completed. The 10 per cent investment in Air China by Cathay [in November] was the first step in cementing a relationship,' said a senior Swire executive. 'Cathay has successfully fought for a small share of the Beijing-Hong Kong and Shanghai-Hong Kong routes, but that is not enough. It knows that it will need full integration into the market.'

Sources suggested a deal could be announced within two weeks.

In November, Cathay paid about $2.91 billion for 10 per cent of Air China during its Hong Kong listing.

Any deal will require consent from multiple shareholders at the listed firms that potentially have divergent interests. Dragonair is controlled by China National Aviation Corp, while Citic Pacific is a significant minority shareholder in both Hong Kong-based carriers.

Any deal is likely to involve a share swap that will reflect Cathay's market value of $48 billion, compared to $26.6 billion for Air China.

The Swire Group would likely emerge as the single largest shareholder in Air China, and executives familiar with the situation said the transaction would make no sense unless Cathay management played a major role in the enlarged group's operations. Cathay is viewed as one of the world's best airlines, while Air China remains plagued by weak management, low-quality service and a poor reputation abroad.

A Cathay spokeswoman said in a statement yesterday: 'We are happy with our relationship with Dragonair and see no reason to change any aspect of it at this time. In regards to Air China, there are no plans to change the existing relationship at the present time.'

An Air China spokesman in Beijing said: 'As far as I know, there have not been any talks since the deal for Cathay's 10 per cent stake was finalised.'

Any consolidation would pose awkward questions for the Hong Kong government, which has been recently encouraged to create a pro-competition policy for the aviation sector.

Asked how the government would respond to the effective merger, Permanent Secretary for Economic Development and Labour Sandra Lee Suk-yee said: 'They have not formally notified us. We would have to have a look at the final shareholding structure.'

Privately, another senior official said the government would be unlikely to act unless 'the actual ownership, or control, is shifted outside Hong Kong'.

A consolidation of the three carriers would create the world's largest airline by market value and an Asian powerhouse that could feed an international customer base into greater China's most comprehensive route network.

It would also allow the airlines to rationalise their route networks and reduce overhead costs on sectors such as Hong Kong-Beijing, where the potential siblings currently offer 15 flights a day.

Peter Negline, a local aviation analyst for JPMorgan, who first wrote about the merits of a Cathay-Dragonair merger over a year ago, said he believed a consolidation made even more sense now. 'In the current environment of industry liberalisation and high oil prices, these two airlines have the option of flourishing together or risking stagnation. The need to rationalise their shareholdings is obvious,' he said.

FLIGHT PATHS

HOW THE AIRLINES MATCH UP

1948 Cathay Pacific Airways is incorporated and begins scheduled services in Asia Pacific. Swire Group is major shareholder

1986 Cathay is listed on Hong Kong stock market

1987 China Investment Trust Corporation buys 12.5 per cent of Cathay Pacific

1990 Cathay buys 30 per cent of Dragonair, to which it transfers all its China routes

1994 Cathay acquires 75 per cent interest in cargo carrier Air Hong Kong

1996 China National Aviation Corp (CNAC) swaps a 5 per cent holding in Cathay for what has become a 43.29 stake in Dragonair

2003 Cathay and Dragonair face off in a Hong Kong court hearing over mainland route access

2004 Cathay secures limited access to Beijing and Shanghai

2004 Cathay buys 10 per cent of Air China as a strategic investor before its public share offering