By JAMES HOOKWAY | The Wall Street Journal

KUALA LUMPUR, Malaysia — Tony Fernandes, the chief executive of Malaysia’s upstart AirAsia airline, seldom shies away from a fight.

A former executive at Time Warner Inc.’s music division, Mr. Fernandes bought the debt-laden carrier in 2001 for 27 cents and turned it into Asia’s biggest budget airline with $754 million in annual revenues. It hasn’t been easy. To expand AirAsia Bhd., he’s battled reluctant governments for landing rights and routes and has endured price wars with regional competitors.

Now, as Mr. Fernandes pushes to build a new low-cost global hub and expand into Europe, Australia and the U.S., he is running into a tenet of modern Malaysia: affirmative action. Malaysia’s political leaders prefer to see big business such as airports in the hands of the ethnic-Malay majority, and often that means government control.

“A lot of Malaysians are proud of what AirAsia has achieved,” says Mr. Fernandes, a 45-year-old Malaysian of Indian descent. But successes such as his, he believes, are outnumbered by the economic problems created by the affirmative action system. “It’s a very Jekyll-and-Hyde situation here.”

This fertile, tropical nation in the heart of Southeast Asia prides itself on showing that Islam and business are compatible. The country is a significant supplier of palm oil and computer components to the world economy, and it harbors substantial oil and gas reserves. The iconic twin towers which dominate downtown Kuala Lumpur were once the world’s tallest buildings and today are the headquarters of state-owned oil company Petroliam Nasional Bhd.

The gleam and glitter are partly built on a race-based system of quotas and government ownership of key businesses, however, which many economists say now risks retarding the country’s growth. In 1969, race riots between Malays and ethnic-Chinese Malaysians prompted the country’s predominantly Malay leaders to introduce affirmative-action-style policies to give a leg up to the Malay population.

The original goal was to help Malays catch up economically with ethnic-Chinese Malaysians, who comprise around a fourth of the country’s 27 million people but who control a disproportionately large share of businesses and trade. To do so, the government created a series of state investment vehicles to buy into key parts of the Malaysian economy. Officials hoped that private Malay entrepreneurs would eventually emerge to take control.

Forty years on, the policy continues to have an impact in that much of the Malaysian economy remains under government direction. The state investment funds still own controlling stakes in large corporations such as Telekom Malaysia Bhd. and power generator Tenaga Nasional Bhd., as well as aviation companies Malaysia Airports Holdings Bhd. and Malaysian Airline System Bhd. Some of the state-backed companies have proved successful, others less so. Malaysian Airline System is losing money while national car producer Proton Holdings Bhd. is largely kept going by special tax rules, equity analysts say. The two companies didn’t return requests seeking comment.

Thus far, however, relatively few Malay entrepreneurs have capitalized on the race-based initiatives. In the meantime, some economists here say those same programs now threaten to undermine Malaysia’s fortunes by making it tough for some non-Malay entrepreneurs — like Mr. Fernandes — to go up against competitors in countries such as China, Vietnam and Singapore.

The predicament of AirAsia, and whether it should be allowed to develop its own low-cost terminal, is a case in point. Obstacles to the carrier’s growth could jeopardize Malaysia’s status as an international travel hub — and damage the country’s best-known global brand in the process.

All this is distressing to many Malaysians who believe their country, like many other developing nations, needs to do far more to encourage home-grown entrepreneurs.

Since taking office in April, Prime Minister Najib Razak, a Malay, has rolled back some aspects of the race-based program — known here as the New Economic Policy — to lure more foreign investors. He recently issued new rules allowing foreign investors to enter selected service, financial and legal businesses without having to give up equity to local ethnic-Malay partners. Companies listing on the local stock market, meanwhile, will be required to allocate 12.5% of their shares to Malay investors, compared with 30% before. Mr. Najib also urged a level playing field between state-owned business and privately-owned competitors.

“The world is changing quickly and we must be ready to change with it or risk being left behind,” Mr. Najib told an investment conference June 30. But he stressed in an interview that “we mustn’t lose sight of the overall objective of a more equitable and just society.”

Some Malay hard-liners warn that the government has gone too far. Ma’amor Osman, leader of a local activist group of Muslim Malays, describes Mr. Najib as “a dangerous liberal” who could destabilize Malaysia’s fragile ethnic balance, while some protesters have recently marched in support of Malay rights. The country’s Malays comprise just over half its population, and many can’t remember a time when they weren’t entitled to any special privileges.
[Affirmative Action Spurs Asian Debate]

Affirmative action programs provoke controversy wherever they appear. In the U.S., President Barack Obama’s election victory has injected some fresh life into a debate over whether race-based preferences for university places or government jobs are still needed or desirable. India’s efforts to improve the lot of people born on the lower rungs of that country’s caste system were a major factor in elections there this year.

Proponents of the NEP say the measures helped create a stable country attractive to foreign investors who built electronics factories, chip plants and other businesses here. This foreign investment, along with the discovery of oil in Malaysian waters, helped drive the country’s economic growth from the 1970s to the 1990s.

“The idea was to grow the pie so everybody could have a larger share,” says Razaleigh Hamzah, an aristocrat picked by the government in the 1960s and 1970s to set up banks and run other state-controlled businesses.

Nonetheless, some non-Malay businesses had to hand over 30% of their equity to ethnic-Malay partners. The government also introduced quotas reserving 55% of the places at Malaysia’s state universities to Malay students, forcing others to educate their children at expensive private colleges or overseas.

Last year, AirAsia’s Mr. Fernandes issued a challenge to this status quo. Instead of paying landing fees, passenger-service charges and other dues set by Malaysia’s state-owned airport company, he proposed that AirAsia build its own airport facilities, including the construction of a Disneyland-style resort, and set its own, lower rates.

Behind the expansion plans are several other practical concerns. AirAsia’s current terminal at the main Kuala Lumpur International Airport complex is little more than a glorified cargo hanger. Passengers await boarding calls huddled in groups, like at a bus or railway station, and walk across the tarmac to their planes. Other international airlines, by contrast, operate from an ultramodern terminal nearby where passengers are whisked to their departure gates on a sleek monorail train.

When the global economic crunch hit, Mr. Fernandes expanded through the slump, launching several new routes and increasing AirAsia’s capacity by nearly a fifth in a bid to lure customers from traditional airlines. Net profit in the first quarter hit 203.2 million ringgit, or $57 million, up 26% from the same period last year. Still, AirAsia is $2 billion in debt — partly the result of its rapid expansion. To keep the business aloft and healthy, Mr. Fernandes argues that AirAsia needs cheap, but effective airport facilities.

AirAsia also plans to use its base in Kuala Lumpur as a hub for a new long-haul service called AirAsia X, which counts Sir Richard Branson’s Virgin Group among its major shareholders. AirAsia X currently flies to Australia and Britain, but Mr. Fernandes hopes the airline will soon serve the U.S., too.

The Malaysian government initially agreed with AirAsia’s plans and consented to the $460 million airport project. Then, in January of this year, local bureaucrats began pushing back. State investment fund Khazanah Nasional Bhd. objected to Mr. Fernandes’s plans. It insisted that if a new facility was to be built, it should be erected and managed by one of its closely held assets, Malaysia Airports, at the existing airport complex.

Another of Khazanah’s assets, Malaysia Airlines, also stood to lose from AirAsia’s expansion. That spurred concerns in the industry that Khazanah was attempting to protect its own investments rather than help fuel the growth of AirAsia, which last year accounted for 40% of all passengers coming through Kuala Lumpur International Airport.

Khazanah officials didn’t respond to requests for comment. A representative of the state investment fund said it objected to the AirAsia plan because there was an existing airport complex and building another one was an unnecessary expense.

Still, Malaysia’s government quickly reversed course after Khazanah flagged its objections. Mr. Najib, deputy prime minister and finance minister at the time, instructed state-run Malaysia Airports Holdings and AirAsia to work out a possible compromise: Malaysia Airports could build and run the new terminal, but to AirAsia’s specifications. It seemed like a win-win solution at the time, AirAsia officials said.

But after five months of talks, Mr. Fernandes and other AirAsia executives say they still have no idea kind of fees they’ll have to pay. They’ve suggested passenger service charges of 10 ringgit ($2.82) for international flights and six ringgit ($1.69) for domestic flights, a discount from the 25 ringgit AirAsia and other airlines usually pay because of the limited budget services AirAsia offers. Malaysia Airports officials didn’t respond to requests for comment.
[Affirmative Action Spurs Asian Debate]

In a May 26 letter to the chairman of Malaysia Airports, AirAsia Chairman Aziz Bakar warned that high airport charges would “delay the launch of new routes,” discourage tourists and “place in jeopardy this economic boon for the nation.” AirAsia may also slow down its fleet expansion, at least for its shorter-haul sector, said the letter, which was reviewed by The Wall Street Journal.

Some airline analysts say AirAsia may be able to adopt a hard-line stance in its negotiations because of the sheer quantity of passengers it channels through the Kuala Lumpur International complex. “The airport had been languishing somewhat before AirAsia came along,” says Peter Harbison, director of the Centre for Asia Pacific Aviation, a Sydney, Australia, consulting firm.

Already, the carrier is bringing people through Malaysia who might not have otherwise come. One such tourist, Domingo Buenaseda, from the Philippines, recently strolled a Kuala Lumpur mall. “A friend was getting married in Bali, Indonesia, and flying on AirAsia was the cheapest way of getting there,” he said. “Stopping off in Kuala Lumpur for a few days for the connection seemed like a good idea.”

No one knows when, if ever, AirAsia and Malaysia Airports will be able to thrash out a deal. Singapore this year allowed AirAsia to fly from the city-state to other countries for the first time, after rebuffing Mr. Fernandes’s overtures for seven years. That means AirAsia could potentially use Singapore as a hub instead of Kuala Lumpur.

A spokeswoman for the Civil Aviation Authority of Singapore says the city’s airport is offering incentives to all airlines to fly from Singapore — AirAsia included.

—Shai Oster in Beijing contributed to this article.
Write to James Hookway at [email protected]