Xinhua Far East China Credit Ratings downgraded the domestic currency issuer credit rating of China Southern Airlines Ltd from BBB to BB+.

The downgrade is prompted by Xinhua Far East's concerns that it will be very challenging for CSA to turn around its operations and significantly reduce its high financial gearing amid soaring jet fuel costs and intensifying competition in China's aviation market. As such, it will be difficult for the company to restore its credit profile that is commensurate
with the requirements of an investment grade rating.

The company has reported after tax net loss since financial year 2003 and it has recently announced an earning warning that it expected to continue to report a net loss for the first half of 2005. At the same time its peers Air China Ltd and China Eastern Airlines Ltd managed to rebound from setbacks by SARS in 2003 and became profitable in 2004.

While CSA's acquisitions of regional airlines in 2004 reinforced its position as the largest airline in China with the most extensive domestic routing network, the acquisitions brought about substantial rise in debts and financial leverage, and dragged down its operating efficiency. Including the liabilities under financial leases, the company's total debt increased from RMB 18.9 billion in 2003 to RMB 35.3 billion in 2004, and further up to RMB 40.5 billion as at end of first quarter of 2005. Correspondingly, its total debt to total capital ratio exhibited a rising trend, from 58.2% in 2003, to 71.8% in 2004 and to 74.5% as at March 31, 2005.

Despite the sharp rise in revenues by organic growth and acquisitions, soaring jet fuel costs have considerably eroded CSA's profitability. It is noteworthy that prevailing regulatory framework hinders CSA from fully and immediately transferring the hikes in fuel costs to the passengers in domestic routes. Furthermore, the progressive liberalization of China's domestic air transportation fuels increasing competition among domestic airlines and consequently constrains airlines' flexibility to increase airfares. Thus, even though CSA's extensive domestic network enables it to enjoy the burgeoning growth potentials in domestic aviation, its large exposures to domestic routes makes it more vulnerable to increases in fuel price.