* BHP, Rio to combine Aussie iron ore operations
* Rio walks from $19.5 bln deal with Chinalco
* Rio to raise $15.2 bln in deeply discounted rights issue
* BHP stock surges 9 pct on news, Rio rises 10 pct (Adds Chinalco, government, shareholder comments, Rio CDS)
By Sonali Paul
MELBOURNE, June 5 (Reuters) - Global miner Rio Tinto (RIO.AX) (RIO.L) dumped plans for a $19.5 billion tie-up with China's Chinalco and agreed to set up an iron ore joint venture with rival BHP Billiton (BHP.AX) and sell new shares to slash debt.
The new plan represents a victory for Rio shareholders who had opposed the deal with Chinalco, arguing it favoured the Chinese state firm and could give China greater influence over pricing of key commodities such as iron ore.
Shares in Rio jumped as much as 13 percent to a 7-month high of A$75.75, nearly triple the price of the rights issue at A$28.29 a share, while BHP shares rose 10 percent to A$38.60.
Rio had lined up the deal with Chinalco in February as it was desperate to pay off half its $38 billion in debt as it battled tight credit markets and a commodity price slump and had failed to sell assets to raise cash. But as equity, commodities and credit markets eased, options opened up for Rio Tinto, and shareholders stepped up pressure on it to revise the Chinalco deal.
"We were not supporters of the Chinalco transaction. We're happy to see this alternative approach to solving Rio's issues with its debt," said Ross Barker, managing director of Australian Foundation Investment Co, Rio Tinto's sixth-largest shareholder in Australia and a BHP shareholder, according to Reuters data.
"A deal like this was really essential from Rio's point of view. And it's a good deal for BHP," he said.
Rio and BHP (BLT.L), the world's second- and third-largest iron ore miners, agreed to combine the operations into a 50-50 joint venture, generating savings of at least $10 billion.
BHP, which dropped a bid to buy Rio last year, will pay Rio Tinto $5.8 billion to take its equity interest in the venture to 50 percent, but it stressed the agreement was non-binding at this stage.
The two companies agreed to keep their iron ore marketing separate, a key factor designed to win approval from competition regulators, especially the European Commission, which last year raised concerns about BHP's proposed takeover of Rio due to the impact on iron ore markets.
Chinalco, which remains Rio's biggest single shareholder, said it regretted Rio's decision after it had worked hard to try to revise the deal to reflect changed market conditions as well as shareholders' and regulators' concerns.
"As a result, we are very disappointed with this outcome," Chinalco President Xiong said in a statement.
For more on Rio/Chinalco, click [ID:nSP393349]
"My initial reaction is that it will be overwhelmingly positive for both companies because of the cost savings (and) the synergies," said Michael Bentley, resources portfolio manager at Northward Capital.
The cost of insuring Rio Tinto's debt fell 35 percent after the deal was announced. The spread on its credit default swaps (CDS) narrowed to around 190 basis points from 290 bp.
"We consider these initiatives are a superior outcome for Rio's credit quality as opposed to the Chinalco deal," Nomura International said.
It said it was much better that Rio was selling equity instead of convertible bonds, maintaining greater ownership of its assets, gaining joint venture savings and would not have a conflict with a major customer as a big shareholder.
The prospects for Chinalco were less clear.
Under the deal agreed in February, Chinalco would have paid $12.3 billion for stakes in Rio's key iron ore, copper and aluminium assets and $7.2 billion for convertible notes that would have doubled its equity stake in Rio to 18 percent.
"A significant component of BHP and Rio's success going forward is to ensure that they reestablish good relations with the Chinese despite the fact the Chinalco deal with Rio has fallen over," said Shaw Stockbroking dealer Jamie Spiteri.
The prospects of winning approval from the Australian Competition and Consumer Commission for the joint venture are good, as the regulator last year did not seek to block BHP's proposed takeover of Rio.
"On the face of it, given that it was approved previously, there would have to be a compelling argument as to why this wouldn't be (approved) by the ACCC," Australian Trade Minister Simon Crean said.
BHP launched a 3.4-for-1 share swap to take over Rio in February 2008, which Rio rejected saying it vastly undervalued the firm and its prospects. BHP dropped the deal last November after commodity markets collapsed. (Additional reporting by Sydney and Melbourne newsrooms; Writing by Sonali Paul and Lincoln Feast; Editing by Jean Yoon)