French car maker PSA Peugeot Citroen's
alliance talks with General Motors may yet fail as the U.S. automaker hesitates over criticism from investors, a source with knowledge of the discussions said.

Intense public scrutiny is also undermining the draft deal, in which GM would take a small Peugeot stake as part of a 1 billion euro ($1.34 billion) share issue by the cash-strapped French automaker, the source said, adding: This is not a done deal yet.

Peugeot has yet to offer any public statement, more than 18 hours after France's AMF market watchdog demanded a response to press reports on the discussions that sent its shares yo-yoing. GM has also declined to comment.

The Detroit-based automaker is not completely convinced by the draft deal on the table, the source said.

GM shares have dropped 4.4 percent since the alliance plan was first reported by a French newspaper on February 21, while Peugeot's have advanced 6.6 percent.

This is not the type of solution we need to see in the European mass market, where capacity has to leave, Credit Suisse analyst Erich Hauser told investors in a note on the tie-up talks.

Like Peugeot, GM's Opel division is struggling to reverse mounting European losses compounded by the region's auto sales slump and cut-throat price competition. GM's European operations lost $747 million last year, while Peugeot's core auto division was 497 million euros in the red in the second half.

The French government is still waiting for information from Peugeot about the alliance plan, an official said on Wednesday.

Citing unnamed staff at Peugeot's main research and development centre outside Paris, financial daily Les Echos also reported that a recent visit by GM executives went badly.

On Tuesday, Peugeot shares had soared almost 10 percent after sources told Reuters that GM planned to buy a Peugeot stake, before giving up nearly all their gains on reports of a broader capital increase.

Peugeot must issue a statement on this subject as soon as possible, in compliance with stock market law, the AMF said after the Paris market closed yesterday. The regulator reiterated its statement on Wednesday.

Peugeot last week confirmed that alliance talks were underway, without identifying the potential partner.

The Peugeot family, which owns just over 30 percent of the car maker, has signaled that it would not be opposed to some dilution providing it remained the principal shareholder.

Despite the tie-up discussions, Peugeot remains a favorite for short sellers with 8.6 percent of outstanding shares on loan, according to London-based Data Explorers - making it the third most shorted stock on France's benchmark index. ($1 = 0.7450 euros)

(Additional reporting by Julien Ponthus and Blaise Robinson in Paris; Editing by Chris Wickham)