Hong Kong airline Cathay Pacific is buying its rival Dragonair for HK$8.22 billion (US$1.05 billion) to expand its flight network on the Chinese mainland.

Cathay Pacific currently operates just two passenger routes between Hong Kong and the mainland. It will now be able to take over Dragonair's 23 mainland routes.

As part of the deal, Cathay will also spend HK$4.7 billion (US$605.5 million) to double its stake in Air China to 20 per cent. In return, Air China will pay HK$5.39 billion (US$694.4 million) for 10 per cent of Cathay.

Cathay Pacific and Air China also said they planned to set up a joint cargo airline based in Shanghai.

A total of 51 per cent of that firm will be owned by Air China, with 49 per cent owned by Cathay. Neither company has disclosed further details about the new airline.

"Gaining mainland access will give unlimited possibilities to Cathay Pacific, and I believe it will have the ability to turn around any unprofitable routes that Dragonair currently has, and reduce its costs significantly," said Peter Drolet, senior analyst at UOB Kay Hian, a Hong Kong-based stock brokerage house.

Because of an earlier arrangement between Cathay and Dragonair, the former's presence on the mainland has been limited to passenger routes from Hong Kong to Beijing and Xiamen.

But rumours about the company taking over Dragonair, which will keep its current branding under the new deal for at least six years, have been floating around for years.

"The reshuffle of Cathay and Dragonair will reinforce the status of Hong Kong as an international aviation hub," said Steven Ip, secretary for economic development and labour in Hong Kong.

"Hong Kong will be the main channel for foreign travellers to the mainland."

Cathay, which already held a 17.8 per cent stake in Dragonair, is buying the shares that it does not own from its own parent, Swire Pacific, as well as CITIC Pacific and China National Aviation (CNAC) for HK$820 million (US$105.6 million) in cash and the remainder in new shares.

The deal will see Swire's stake in Cathay pared from 46.3 per cent to 40 per cent, while CITIC Pacific's holding in Cathay will fall from 25.4 per cent to 17.50 per cent.

Although its holding will decrease, Swire Pacific will remain Cathay Pacific's largest shareholder.

Swire Chairman Christopher Pratt stressed at a press conference in Hong Kong that the firm has no intention to further reduce its stake.

"Air China is a prestigious brand name in the mainland aviation industry and it is an invaluable opportunity for us to enlarge our shareholding in the company."

The combination of Cathay's international reach and Dragonair's well established branding on the mainland will mean several airlines will face stiffer competition, especially Shanghai-based China Eastern and Guangzhou-based China Southern airlines, analysts said.

"Undoubtedly, Cathay will consider the acquisition a springboard to advance its presence on the mainland market," said Casor Pang, a strategist at Sun Hung Kai Financial Group.

If China Eastern is worried, it is not showing it.

"We have a firm hold of at least 40 per cent of the market in Shanghai," Luo Zhuping, secretary of China Eastern's board of directors, said.

"We have the support of the (Shanghai municipal) government and we enjoy special advantage in the choice of facilities at Pudong international airport."

To prepare for the increased competition, China Eastern is planning to close down some of its less-profitable routes to concentrate its resources on Shanghai, Luo said.

"This is our home town and we are ready to take on all comers."