Honda and Nissan are in talks to deepen ties, two people said on Wednesday, including a possible merger, the clearest sign yet of how Japan's once seemingly unbeatable auto industry is being reshaped by challenges from Tesla and Chinese rivals.

A combined Honda and Nissan would create a $54 billion company with annual output of 7.4 million vehicles, making it the world's third-largest auto group by vehicle sales after Toyota and Volkswagen.

The two firms already forged a strategic partnership in March to cooperate in electric vehicle development, but Nissan's deepening financial and strategic trouble in recent months has added more urgency for closer cooperation with larger rival Honda.

Nissan announced a $2.6 billion cost savings plan last month that includes cutting 9,000 jobs and 20% of its global production capacity, as slumping sales in China and the United States led to an 85% plunge in second-quarter profit.

"This deal appears to be more about bailing out Nissan, but Honda itself is not resting on its laurels," said Sanshiro Fukao, executive fellow at Itochu Research Institute. "Honda's cash flow is set to deteriorate next year and its EVs haven't been going so well."

Shares of Nissan closed nearly 24% higher in Tokyo trade on Wednesday, while shares of Honda, whose market value of $43 billion is more than four times bigger than that of Nissan, declined 3%. Shares of Mitsubishi Motors, in which Nissan is the top shareholder with a 24% stake, gained nearly 20%.

The automakers have been grappling with challenges from EV makers, particularly in China, where BYD and others have surged ahead. 

U.S. President-elect Donald Trump is also threatening hefty tariffs on vehicles shipped from Canada and Mexico to the U.S., adding further pressure on the companies. Honda and Nissan both produce cars in Mexico for export to the United States.

The talks between Honda and Nissan, first reported by the Nikkei newspaper, could allow the companies to cooperate more on technology and help them create a more formidable domestic rival to Toyota.

The discussions are focused on finding ways to bolster collaboration and include the possibility of setting up a holding company, said the people, who declined to be identified because the information has not been made public.

The companies are also discussing the possibility of a full merger, according to one of the people, as well as looking at ways to cooperate with Mitsubishi.

Honda, Nissan and Mitsubishi said no deal had been announced by any of the companies, though Nissan and Mitsubishi noted the three automakers had said previously they were considering opportunities for future collaboration.

French automaker Renault, Nissan's largest shareholder, is open in principle to a deal and would examine all the implications of a tie-up, two people familiar with the matter said.

A Renault spokesperson declined to comment.

Renault shares were up 6.7% at 1352 GMT, set for its best day in just under 2-1/2 years.

The three Japanese automakers are expected to hold a joint news conference in Tokyo on Monday, according to a source familiar with the matter.

Taiwan's Foxconn, which manufactures Apple's iPhones and has been seeking to expand its nascent EV contract manufacturing business, approached Nissan about a bid but it was rejected by the Japanese firm, two separate sources familiar with the matter said.

Bloomberg News reported earlier on Wednesday that Foxconn had approached Nissan to take a controlling stake.

Foxconn did not immediately respond to a request for comment, while a Nissan spokesperson declined to comment on Foxconn.

CHANGING LANDSCAPE

Any merger would face significant U.S. scrutiny after Trump has vowed to take a hard line on imported vehicles. He could seek concessions from Honda and Nissan to approve any deal, auto industry officials said.

Over the past year, an EV price war launched by Tesla and BYD has intensified pressure on any automakers losing money on the next-generation vehicles. That has pushed companies like Honda and Nissan to seek ways to cut costs and speed vehicle development, and mergers are a major step in that direction.

"In the mid- to long-term, this is good for the Japanese car industry as it creates a second axis against Toyota," said Seiji Sugiura, a senior analyst at Tokai Tokyo Intelligence Laboratory.

"Constructive rivalry with Toyota is a positive for the rather stagnating Japanese car industry when it must compete with Chinese automakers, Tesla and others."

S&P Global Ratings said it would take time for the synergies from a potential merger to boost the firms' creditworthiness.

Differences in corporate culture and strategies may mean a merger that does not give one side control is unlikely to have meaningful results.

"In our view, there have been few instances where mergers and alliances between major automakers have led to significant benefits," it said in a note.

Honda and Nissan would also have to work out how to integrate their different corporate cultures if they proceed with a merger, analysts said.

"Honda has a unique, technology-centric culture with strengths in powertrains, so there should be some internal resistance to the merger with Nissan, a competitor with a different culture that is now faltering," said Tang Jin, a senior researcher at Mizuho Bank.