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.

The discussions, first reported by the Nikkei newspaper, would allow the companies to cooperate more on technology and help Honda, the country's second-largest automaker and Nissan, the third-largest, create a more formidable domestic rival to Toyota.

The talks were focused on finding ways to bolster collaboration and included the possibility of a setting up a holding company, said the people.

The companies were also discussing the possibility of full merger, according to one of the people, as well as looking at ways to cooperate with Mitsubishi Motors, in which Nissan is the top shareholder with a 24% stake.

The people declined to be identified because the information has not been made public.

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

A combined Honda and Nissan would become the world's third-largest auto group by vehicle sales after Toyota and Volkswagen and remain in that position if it also included Mitsubishi.

"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."

Shares of Nissan surged more than 22% in Tokyo trade on Wednesday, while shares of Honda declined 2.3%. Shares of Mitsubishi rose 13%.

Honda's market capitalisation is about $44 billion, while Nissan's is about $10 billion after price surge on Wednesday, meaning a full merger would be bigger than the giant $52 billion deal between Fiat Chrysler and PSA in 2021 to create Stellantis .

Changing landscape

Honda and Nissan have formed ties in recent months as they wrestle with the changing electric vehicle landscape, considering a strategic partnership to collaborate on producing key components for EVs and artificial intelligence in automotive software platforms.

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

As well as heavy competition, automakers also face stalling demand in Europe and the U.S.

Nissan, in particular, has been struggling and announced a plan last month to axe 9,000 jobs and 20% of its global production capacity to reduce costs by $2.6 billion in the current financial year ending in March.

"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."

French automaker Renault, a major Nissan shareholder, said it had no information and declined to comment.