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British Airways and Spanish flag carrier Iberia on Thursday signed a merger deal to create one of the world's biggest airlines to compete more effectively in the fast-consolidating aviation sector, Agence France Presse reported.

The tie-up will create Europe's second-biggest airline by market capitalisation after Lufthansa, combining Iberia's strong position in Latin America with BA's presence in Africa, Asia and North America.

'British Airways and Iberia have today taken a further step towards creating a new leading European airline group by signing their merger agreement,' the two loss-making airlines said in a joint statement.

'The new company will be one of the world's largest airline groups with 408 aircraft flying to 200 destinations and carrying more than 58 million passengers per year.

'It has been structured so that it can take advantage of further consolidation in the global aviation industry,' they said, adding that it would benefit both airlines' customers, employees and shareholders.

The landmark deal would create annual savings of around 400 million euros (533 million dollars) by the fifth year of the deal.

The tie-up, which requires regulatory and shareholder approvals, is expected to be completed by late 2010 and follows a preliminary accord in November.

'The merged company will provide customers with a larger combined network,' said BA chief executive Willie Walsh.

'It will also have greater potential for further growth by optimising the dual hubs of London and Madrid and provide combined investment in new products and services.'

Iberia chairman Antonio Vasquez also hailed the deal as a major step forward, as both airlines seek to avoid being sidelined by rivals Air France-KLM and Lufthansa.

'This is an important step in the process towards creating one of the world's leading global airlines that will be better equipped to compete with other major airlines and participate in future industry consolidation,' Vasquez said.

Under the agreement, BA and Iberia will be grouped under a new holding company, known as International Airlines Group, which will be quoted on stock exchanges in London and Madrid.

However, both airlines will retain their current operations and individual brands.

Iberia will keep the right to terminate the merger deal if BA's pension recovery plan is deemed to be 'materially detrimental' to the merger.

Analysts gave a cautious welcome to Thursday's news.

'Moving closer to a merger with Iberia could not have come at a better time for British Airways, but still needs to be treated with caution,' said trader Manoj Ladwa at ETX Capital.

'Not only is the deal subject to EU approval but the small issue of their pension deficit could still scupper the deal.

'Although any tie-up does not address recent woes, the long-term savings could be substantial and solidify the airline's future.'

The BA-Iberia merger comes as the global downturn and the rise of low-cost airlines drives airline alliances and steep cost cutting.

Both groups have suffered steep losses as the global recession slammed the brakes on demand for air travel.

At the same time, BA has faced industrial action from cabin crew over its cost-cutting plans that are aimed at stemming losses.

The pair had signed a preliminary deal last November after lengthy negotiations, but Iberia said at the time it would back out of the agreement if BA's giant pension deficit problem were not resolved.

Under the initial agreement set out in November, BA will own 56 percent of the new company while Iberia will hold 44 per cent. Walsh would retain his position as chief executive, while Iberia would secure the chairmanship.

The new group would be headquartered in Madrid, but its operational base would be in London.