Employees of French carmaker PSA Peugeot Citroen work on the new engine "EB" assembly line at the company engines factory in Tremery near Metz, North Eastern France, December 1, 2011. REUTERS/Vincent Kessler (FRANCE - Tags: TRANSPORT BUSINESS)

PSA Peugeot Citroen has long resisted the overtures of rival Fiat, but now an alliance, fraught with difficulties though it may be, may be the only way to close the widening gap with European market leader Volkswagen.

Wolfsburg's financial clout and global reach mean the smaller players will fall further behind if they don't team up to cut capacity and share the costs of developing new cars.

VW plans to invest €62 billion (R635 billion) in new models from 2011-2016, competed with PSA 's €3.7 billion (R38 billion) average annual spending research and development over the past three years, €26 billion (R266 billion) earmarked for 2010-14 by Fiat and Chrysler, the Italian carmaker's US partner.

Demand in Western Europe is still shrinking, which is a really big problem for Fiat, which sells 45 percent of its production there, and PSA, 54 percent of whose customers live in the EU.

Fiat and Chrysler boss Sergio Marchionne said at the recent Detroit motor show he would “certainly take a look” at PSA, adding that Europe needed a new car giant able to rival Volkswagen's 23.3 percent market share - but denied a newspaper report that talks were underway.

Renault is already allied to Nissan pursuing joint programs with Daimler so PSA is the only manufacturer that could come close to fitting the bill for Fiat, but a tie-up between the two is easier said than done.

Fiat has too much capacity, while PSA production is spread among French plants that are too small and costly to stay profitable in a price war.

PSA No.2 executive Frederic Saint-Geours said the day after Marchionne's comments that it was “completely open” to any alliance that boosted performance while preserving its independence, “but you have to find the right partner.”

One company insider said PSA saw a tie-up as a “social and industrial catastrophe” - but the Peugeot family may be running out of options.

The Peugeot 308 and Citroen C4 would bolster Fiat's weak hatchbacks, while PSA doesn't have anything in the minicar segment where the Fiat Panda excels.

Marchionne said in Detroit that Fiat was interested in sharing an A and B platform, enabling it to save billions on development costs.

Fiat's Punto and the Opel Corsa share a B platform developed with General Motors, that still has another product cycle of seven years left in it but its A platform, used by the best-selling Panda, will need to be replaced sooner.

Gregory Moore, a Paris-based fund manager, said bluntly: “There are just too many carmakers in Europe. “One way or the other, there will have to be mergers.” - Reuters