* Fiat to hold 35 percent of Chrysler; may hike stake
* Daimler still looking to sell Chrysler stake
* France eyes 5-6 billion euro auto bailout
* Merkel says bailouts no solution to sector's woes
* BMW cuts hours for 26,000 workers
(Adds more Chrysler CEO comments, Fiat share price)
By Gilles Castonguay and Poornima Gupta
MILAN/DETROIT, Jan 20 (Reuters) - Italy's Fiat took an initial 35 percent stake in Chrysler, launching a venture designed to secure both carmakers' futures as France asked its auto industry to commit to output targets in exchange for aid.
Chrysler said on Tuesday the deal, which involves no cash investment, was a key component in its survival plan, giving it access to Fiat's more fuel-efficient vehicle platforms and freeing up an immediate $4 billion of funds from the U.S. government's Troubled Asset Relief Program (TARP).
News of the transatlantic partnership broke as politicians struggled to fashion a coordinated response to the worst crisis to hit the auto industry in decades.
French Prime Minister Francois Fillon said his government was considering an aid package for the country's carmakers worth 5-6 billion euros.
"I think all European governments share this opinion ... There is an emergency. We need a massive response on the automobile sector's financing," he told a French car industry summit. Measures would be announced in the coming days, he said.
But as German carmakers also took steps to bolster haemorrhaging cash reserves, Chancellor Angela Merkel criticised U.S. subsidies to the sector and warned that state bailouts risked distorting competition and did not offer a long-term solution to the crisis.
ECONOMIES OF SCALE
The Chrysler stake, which Fiat's vice-chairman John Elkann said might be increased, would give the Italian carmaker the scale it needs to survive, while Chrysler can expand its portfolio to include less-polluting cars, meeting criteria for access to U.S. funds.
The U.S. carmaker's CEO, Bob Nardelli, told employees in a letter the Obama administration would provide $4 billion of initial funding to Chrysler, and that the company would assist in bringing its partner's brands to the U.S. market.
He said the deal, which is expected to be completed in April pending regulatory approvals, would "significantly enhance the long-term viability" of the company and "greatly increase (our) global reach ... in markets outside of North America."
Cost savings from the collaboration are estimated at $3-$4 billion, the Wall Street Journal reported on Tuesday.
"Sharing technology should inevitably save costs," said Bank of America Merrill Lynch analyst Harald Hendrikse.
"Fiat is looking at Chrysler as an inexpensive way to re-enter the U.S. market ... (and) should gain access to cheap U.S. assembly."
However, Fiat's optimism about the deal was surprising, given that "what Daimler or private equity could not fix is not likely to be fixed by Fiat", he said.
At 1403 GMT, Fiat shares jumped 4.1 percent to 4.66 euros after being halted from trade ahead of the news, while the DJS European auto sector gained 1 percent.
In Germany, a spokesman for former Chrysler owner Daimler, which still holds a 20 percent stake, said the German carmaker was continuing efforts to sell its holding and welcomed any initiative that served to stabilise the situation at the U.S. carmaker.
Daimler has written down the value of that stake to zero.
Domestic rival BMW on Tuesday became the latest manufacturer to scale back production amid a relentless rise in inventories as sales plummet, putting 26,000 German staff on shorter working hours in February and March.
French Prime Minister Fillon said that in exchange for state aid carmakers would have to give commitments on production volumes as well as safeguarding jobs.
A senior official in President Nicolas Sarkozy's office said France did not expect the European Union to raise objections to the plan, and that the government wanted a certain degree of collaboration with other European countries in the auto sector.
Peugeot chief executive Christian Streiff warned on Monday that 2009 would be a "terrible year", while his counterpart at Renault-Nissan, Carlos Ghosn, forecast on Tuesday that the auto sector downturn would be long-lasting.
In Tokyo, the world's biggest carmaker Toyota Motor Corp named the grandson of its founder to steer it through the crisis.
WEAKEST OF 'BIG THREE'
The Fiat deal is the latest in a series of alliances that car makers have formed to cut costs and improve margins.
The weakest of Detroit's three carmakers, Chrysler has been counting on a further $3 billion of government loans to avoid collapse.
Like General Motors, which also got government money, Chrysler was required to meet cost-cutting targets as a condition for the loans. It also has to show it is committed to developing new vehicles that produce fewer harmful emissions.
Analysts had questioned whether Chrysler could survive without a partner. Most of its sales are in the U.S. market, where Chrysler posted a 30 percent drop last year. (Additional reporting by Helen Beresford, Claudia Cristoferi, Marcel Michelson, Gianni Montani and Emmanuel Jarry; writing by John Stonestreet; Editing by Jon Loades-Carter)