French carmaker PSA Peugeot Citroen could buy a large stake in Japanese peer Mitsubishi Motors Corp as part of a plan to deepen ties to ride out the industry's worst ever slump.

The companies said on Thursday they were in talks to strengthen an existing relationship, which would create a leader in electric vehicles, with Mitsubishi, whose shares rose 13.4 percent, saying a capital tie-up was possible.

A spokesman for Peugeot, ranked eighth in the world by 2008 sales volume, would not comment on how long talks could last.

Peugeot will face increased competitive pressure from domestic rival Renault SA which is looking to beef up its synergies with 10-year equity partner Nissan Motor.

That Franco-Japanese alliance is looking to lead the industry in the unproven electric car segment, where Mitsubishi Motors is among the only players to have such a car on sale.

Peugeot's interest in Mitsubishi Motors, ranked seventh of Japan's eight carmakers by January-October production, is in line with the recent push by new chief executive Philippe Varin to create a more global car company.

Varin, who took on the role in June, has said this could be achieved by various means, including alliances with carmakers.

Mitsubishi Motors shares closed 13.4 percent higher after the Nikkei business daily reported Peugeot, Europe's second-biggest carmaker, may take a 30-50 percent stake for up to 300 billion yen ($3.4 billion).

Peugeot shares were up 0.4 percent by 1040 GMT.

In the car sector there is overcapacity in the world and in case of overcapacity there could be consolidation French Finance and Economy Minister Christine Lagarde told LCI television. That Peugeot and Mitsubishi have been talking to each other for a while is a good thing, she said.

The Nikkei newspaper said top management at Mitsubishi were ready to accept a majority acquisition of the company by Peugeot if conditions were right.

CM-CIC analyst Guillaume Angue said in a note the alliance would make sense from an industrial viewpoint and it would allow Peugeot to solve its problems of size, but it would come a bit early in the business cycle.

Mitsubishi remained expensive with an enterprise value to sales ratio of 0.64 against 0.2 at Peugeot, he said.

Morgan Stanley analyst Adam Jonas said in a note there were no significant areas of near-term savings, adding cultural/integration risks are extremely high, while the negotiation process, especially regarding financing, could take up to several months.

IDEAL PARTNER

For Mitsubishi Motors, Peugeot would be the ideal partner, said Okasan Securities auto analyst Yasuaki Iwamoto.

It would be tough for Mitsubishi to shoulder R&D costs for environmental technologies on its own and, if you look at the global auto industry, there is a limited pool of partners to choose from.

Both Peugeot and Mitsubishi have so far attempted to compete with bigger rivals through non-equity tie-ups, even as others sought deeper alliances to weather the slump brought on by the global downturn.

Among such moves, Italian Fiat has scooped up Chrysler, while General Motors, the other U.S. auto giant that filed for bankruptcy this year, is fielding interest for several of its brands.

Peugeot itself has operational ties with carmakers ranging from Toyota Motor Corp to BMW.

Peugeot and Mitsubishi have three ongoing projects: a joint venture factory in Russia, an original equipment manufacturing deal in sport utility vehicles, and, most recently, a plan for Mitsubishi to supply i-MiEV electric cars under French brands.

For Mitsubishi Motors, the deeper talks with Peugeot mark a reversal of its attempt to stick it out on its own with the backing of the powerful Mitsubishi group, since dissolving its equity ties with the former DaimlerChrysler group in 2005.

The Nikkei said the two companies were in the final stages of negotiations, with Peugeot seeking a stake of more than 50 percent in Mitsubishi through the placement of new shares.

Mitsubishi may also potentially buy an interest in Peugeot, the paper said.

Shares in Mitsubishi Heavy, the carmaker's top shareholder with a 15 percent stake, ended up 4.7 percent. Trading house Mitsubishi Corp, which holds 14 percent, gained 3.7 percent, while Mitsubishi UFJ rose 2.3 percent.

(Additional reporting by Taiga Uranaka, Yuko Inoue and Nathan Layne in TOKYO, Brenton Cordeiro in BANGALORE, and Marcel Michelson and Helen Massy-Beresford in PARIS; Editing by Lincoln Feast and Dan Lalor)

($1 = 87.45 yen)