The government had been in on-and-off talks with Volkswagen since 2004 over an alliance, fuelling investor hopes that Europe's biggest carmaker would transform the loss-making firm and take it global, as it did with Czech carmaker Skoda Auto.
The government's announcement that Proton would go it alone took the market by surprise. The stock tumbled 12 percent to 4.36 ringgit by the midday break, its lowest since early 2001.
We cannot hide our disappointment of the outcome of the talks, said TA Securities analyst Ikmal Hafizi. We were hopeful that this white knight could be the one.
The government felt Proton should be given a chance to return to profitability on its own steam, following strong sales of its latest model and export plans to Iran and China, Second Finance Minister Nor Mohamed Yakcop said in explaining the Tuesday decision.
But analysts questioned the government's rationale.
To establish oneself in a global scale, one would need strong sales numbers and economies of scale to cushion the fierce price war, TA's Ikmal said.
Proton does not even have this at home, let alone overseas. It still needs the network and very strong brand name to catapult itself in the overseas market.
Proton has only a third of the entire Malaysian passenger car market, which totaled 367,000 units last year.
A pact with Volkswagen would have offered Proton access to car markets in the United States and Europe and become part of a group that will sell more than 6 million vehicles this year. For Volkswagen, it would have given it a low-cost production base in Southeast Asia, home to more than 500 million people.
The government called off the talks with Volkswagen after intense lobbying by Proton's management, who asked to be given a chance to turn the company around, as well as some of Proton's rivals, a source familiar with the talks said.
Rival firms DRB-Hicom Bhd and the unlisted NAZA Group, which assemble and distribute foreign marques in Malaysia, had feared a Volkswagen-Proton alliance would usher in fierce new competition into the local market, the source added.
Shares in DRB, which assembles Mercedes and Isuzu vehicles, jumped at the opening bell but fell back 3 percent to 1.76 ringgit at the midday break.
NAZA assembles cars made by France's Peugeot PSA Peugeot Citroen and South Korea's Kia Motors Corp.
In going it alone, Proton has also shut the door on General Motors, which had also looked at a possible alliance but was always seen as a less likely partner than Volkswagen.
Brokers said the government's decision had also cast further doubt over its pledge to sell down equity. State-linked firms account for about a third of the value of the stock market.
There's no political will, said one local broker.
Local broker CIMB slashed its target price on Proton to 3.50 ringgit a share, saying it was taken aback by the decision.
Partnering VW would have benefited Proton like it did Skoda, at one time the butt of motoring jokes. Skoda is now its country's biggest firm by sales and biggest exporter, and is aiming to make 616,000 cars this year, reaching an output of 1 million by 2010.
(Reporting by Liau Y-Sing and Hsu Chuang Khoo, editing by Lincoln Feast and Mark Bendeich)