Oct. 31 (Bloomberg) -- Air China Ltd., the country's largest international carrier, may take advantage of the industry's record losses to establish a base in Shanghai, extending its dominance to the domestic market.

Shanghai Airlines Co., which controls 17 percent of the city's traffic, has plunged 80 percent this year. Air China President Cai Jianjiang has said his Beijing-based carrier wants a stake in the smaller airline.

Shanghai, the country's commercial capital, is set to overtake Beijing as China's biggest destination by 2015. The city is the only major market not dominated by a single carrier.

``Shanghai is a key issue in the industry consolidation and Shanghai Air is a strategic proposition for anybody,'' said Damien Horth, a UBS AG analyst in Hong Kong. ``Some sort of transaction is likely.''

Air China has a long-term goal of establishing a hub in Shanghai, said board secretary Huang Bin in an Oct. 13 interview. That will put it in direct competition with China Eastern Airlines Corp., the country's third-largest carrier, which is based in that city.

Record Losses

Shanghai Air yesterday reported its biggest-ever quarterly loss for the three months ended Sept. 30. The carrier had a net loss of 437.4 million yuan ($64 million) compared with a profit of 77.3 million yuan a year earlier.

Shanghai Air joined the country's three biggest airlines in falling to a loss, as the slowest economic growth in five years damped demand for business and leisure travel. International passenger numbers in Shanghai, China's financial center, fell 16 percent last month, according to Airports Council International.

Former Air China Chairman Li Jiaxiang, now the nation's aviation regulator, initiated consolidation plans to create a ``super carrier'' to challenge foreign competitors.

Air China's parent offered to buy a China Eastern stake for at least HK$14.9 billion in January. The proposal was rejected by China Eastern management.

`Terminator'

``Air China is like some kind of terminator for China Eastern's plans,'' said Li Lei, an analyst at China Securities Co. in Beijing. ``China Eastern will really be in trouble if Air China gets Shanghai Air.''

Li recommends selling China Eastern and Air China.

Global air-passenger traffic fell last month for the first time in five years as the credit-market crisis and slowing economic growth deterred tourists and executives from flying, the International Air Transport Association said Oct. 24.

``With a deteriorating macroeconomic backdrop, the record losses are likely to trigger another round of domestic restructuring which would favor Air China,'' said Andrew Au, an analyst at Cazenove Asia Ltd. in Hong Kong. ``It's also an opportune time for the central government to realize its dreams of reforming carriers so that at least one of them would be competing in the international arena.''

China's carriers flew 141.4 million passengers this year through September. The 1.7 percent increase trails the aviation regulator's forecast of 14 percent growth for 2008.

`Worst Time'

China Southern Airlines Co. has trimmed salaries by 10 percent since July and China Eastern has cut services to get through the ``worst time for airlines after the severe acute respiratory syndrome outbreak in 2003,'' according to company announcements.

The country's state-owned Assets Supervision and Administration Commission is pushing mergers between enterprises it oversees to improve competitiveness.

China's so-called Big Three airlines are the result of an earlier round of consolidation in 2002. Shanghai Air was left independent.

``A Shanghai hub is very important to us because we could use it for a lot of international routes,'' Air China's Huang said.

China Eastern desires Shanghai Air to help boost its 37 percent share of the home market to more than half.

Fare Competition

Almost 70 percent of Shanghai Air's routes compete directly with China Eastern, handicapping China Eastern against larger China Southern and Air China, which dominate in their base cities.

Competition hinges on fares. China Eastern and Shanghai Air both charge about 2,660 yuan ($389) for a round trip between Shanghai and Beijing.

``Not a single Chinese airline provides service good enough to influence my decision on who to fly,'' said Wang Zhen, vice president of Virtual Advertising Corp. in Shanghai, who travels monthly to Beijing. ``I just pick the cheaper one.''

An acquisition of Shanghai Air would depend on a Shanghai government decision to transfer the more than 50 percent stake under its supervision.

``Discussions on the options are at the government level,'' Luo Zhuping, 55, director of China Eastern, said Oct. 16. ``We don't have the money without the government's capital injection.''

China Eastern's burdensome debt-to-equity ratio of 1,558 percent may give Air China an opening to buy Shanghai Air.

China Eastern posted a record quarterly loss of 2.33 billion yuan in the three months ended Sept. 30 because of falling travel demand and more expensive jet fuel. That compared with profit of 976 million yuan a year earlier.

Attempted Alliance

The carrier failed to raise HK$7.16 billion ($925 million) earlier this year by selling a stake to Singapore Airlines Ltd. after Air China's parent blocked the deal with a higher bid.

In addition to capital, China Eastern pursued the tie-up to improve its service through an alliance with the world's largest carrier by market value.

China Eastern has lost 90 percent of its market value this year, the most among the country's listed carriers, making it vulnerable to Air China.

``Airlines won't bottom out until there's a clear sign of economic recovery,'' said Ren Jun, an analyst who helps manage $1 billion at China Nature Asset Management Co. in Shanghai.

Target prices for China Eastern's Hong Kong shares are as low as HK$0.50 at HSBC Holdings Plc. The stock rose 18 percent today in Hong Kong to HK$0.94. The Shanghai-traded shares fell 5.8 percent to 2.93 yuan.

Air China dropped 3.7 percent to HK$2.07 in Hong Kong and slipped 4.4 percent to 3.52 yuan in Shanghai. Shanghai Air declined 6.2 percent to 3.48 yuan in the city.

To contact the reporter on this story: Irene Shen in Shanghai at ishen4@bloomberg.net

Last Updated: October 31, 2008 04:31 EDT