DETROIT (Reuters) - Chrysler is on the verge of a Motor City miracle: a make-over in bankruptcy that will bring in new management under Italy's Fiat SpA and its highly touted small car technology.

Rescued from liquidation with $8.6 billion of emergency U.S. government loans and bankruptcy financing, Chrysler has been given a new lease on life.

But what's next?

The new Chrysler will be up against formidable and entrenched competitors in the small vehicle market like Honda Motor Co.

It will also struggle with the aftermath of freezing product development to conserve cash, analysts said.

But in what could be its biggest challenge, the No. 3 U.S. automaker has to break free of a reliance on aggressive discounting and a reputation for poor quality.

In the short term, analysts said Chrysler will have to find a way to hang on until early 2011, when Fiat is expected to debut the first of its smaller cars in the U.S. market.

"The big challenge is not getting through this bankruptcy," IHS Global Insight analyst Aaron Bragman said. "The big challenge is what do they do between the end of this bankruptcy and the arrival of the Fiat vehicles?"

"There is still at least 18 months they have to try to survive in a down market with largely the same showroom and really no extra cash to get them through it," Bragman said.

Industry analyst and consultant Maryann Keller said that estimates of the investments required for the new Chrysler after bankruptcy have been way too low.

"They have to be rebuilt, and we don't even know if Chrysler can be rebuilt," Keller said. "There hasn't been any development work done in the last 12 months."

Chrysler, bought by Cerberus Capital Management from Germany's Daimler AG in August 2007, filed for bankruptcy protection on April 30 under the direction of the Obama administration's auto task force.

Based in Auburn Hills, Michigan, Chrysler was seeking bankruptcy court approval on Wednesday for an assets sale, putting it ahead of an aggressive government schedule.

Chrysler has achieved more to cut costs in a shorter time than most analysts thought possible, including wiping out plants and jobs along with dealerships. Chrysler is due to cut nearly 800 dealerships, or 25 percent of its network, by early June.

It has used the bankruptcy process to eliminate $6.9 billion in debt and to halve a $4.5 billion payment that was due to a union trust fund by making it part of a note and part equity that could be sold later.

SOMETHING OLD, NOTHING NEW

Chrysler's turnaround in the 1980s was partly driven by new cars and the minivan, but a crowded marketplace and dearth of new products could get Chrysler's new incarnation off to a rough start.

Erich Merkle, an independent auto analyst, said Chrysler's market share could drop as low as 5 to 6 percent from 10.7 percent in the first four months of 2009, due to a lack of new models and a decline in residual values.

Chrysler's market share was 12.5 percent in the first four months of 2008.

As a result, of the losses in sales and market share, Chrysler's operations will still be "too bloated" when the automaker emerges from bankruptcy even after the cuts it has made during its reorganization, Merkle said.

"They will have to look for areas to cut," he said. "They will still be too large, still have too much capacity."

Through April, Chrysler was the fifth best seller in the United States behind General Motors Corp, Toyota Motor Corp, Ford Motor Co and Honda.

In the first four months of 2009, Chrysler's sales were down 46 percent from a year earlier,

What's more, Merkle said, when the small Fiats arrive, they may not fit the marketplace. He said demand would be focused on mid-size cars and small to mid-size crossovers, areas in which Chrysler has not recently excelled.

U.S. auto sales have been at a 27-year low, not adjusting for the sharp rise in population. Some executives have called it the worst market in five decades.

But J.P. Morgan analyst Himanshu Patel said in a note on Wednesday that Chrysler's sales, which had been well below the industry in May, appear to have returned to about average.

Analysts have asked whether Chrysler's May sales were supported by incentives and dealer liquidation sales, which would mean those sales could be gone from the company's sales figures by early June.

Bragman said that with expectations of delays for new models of Jeep Grand Cherokee, Chrysler 300 and Dodge Charger, Chrysler's turnaround could take years.

"We need to start seeing new product, we need to start seeing something exciting," Bragman said. "We need to start giving people a reason to believe that Chrysler is coming back."

(Reporting by David Bailey; Editing by Toni Reinhold.)

Meanwhile, the Canadian and US governments have agreed to provide about $8bn in loans to the new Chrysler.

Fiat is not paying anything for its 20% stake, which will give it access to the US car market. It has the option to increase its shareholding in Chrysler in the future.

In return, Chrysler will be able to take advantage of Fiat's expertise in making smaller, more fuel-efficient cars in its existing US factories.

Chrysler, the other domestic automaker, probably won't benefit from GM's woes. Even though it will emerge from bankruptcy sooner than GM, Chrysler still has a weak product portfolio, and new vehicles from partner Fiat won't arrive for a couple of years at least. CSM predicts Chrysler's U.S. market share will dwindle from about 11 percent this year to a mere three percent by 2012.

Fiat may turn to PSA Peugeot-Citroen should Opel bid fail
Fiat's sudden interest in Chrysler and Opel highlight the Italian auto giant’s desire to build a large scale global manufacturing operation, but now that a deal with Opel appears to be far from certain there’s speculation as to where Fiat's interest will fall next. In top contention, it’s been revealed, is France’s PSA Peugeot Citroen group.

With a freshly inked deal with Chrysler, many analysts are speculating that without the stability of Opel backing up the allaince, Fiat may find itself on shaky ground. Equity analysts have described Chrysler as the weakest link in Fiat's current expansion strategy and an alliance with PSA could help Fiat find its feet again, reports Automotive News.

Fiat CEO Sergio Marchionne's eagerness to gobble up as many companies as possible isn't surprising, considering his theory that the global economic crisis will wipe out all but six automakers, leaving just a few major European brands. This largely explains Marchionne's desire to swallow companies like Opel, but if PSA and Fiat were to team up, the results would be even more grand than the potential Fiat-Opel tie up - with possible sales for the combined brand reaching as high as seven million units.

But forging an alliance with PSA might turn out to be more difficult than originally thought, especially considering the French government's recent cash stimulus of €3 billion to the struggling PSA. Additionally, other companies have sought alliances with PSA with little success, partly due to PSA's desire to remain independent.

Should both the options of Opel and PSA fall through for Fiat, then Marchionne may find himself at the negotiating table with another GM brand - the small volume Swedish brand Saab. Failing to strike a deal with Opel and PSA would leave Fiat in a precarious position, and absorbing Saab's struggling business may not be the best manoeuvre for Fiat but it may have no other choice at that point.