But the company added that a definitive agreement had not been reached.

BAe did not comment specifically on speculation that it is about to announce a £14bn merger with Germany's Daimler Chrysler Aerospace (DASA).

The end of the Cold War has seen orders slide

A merger between BAe and DASA would create a company with £15bn in sales, with potential cost savings of around £250m a year.

BAe would be the majority partner, with 65%, and Sir Richard Evans, BAe's chairman, would be expected to head the enlarged group.

Such a move would put pressure on the UK's other main defence contractor, GEC, which specialises in defence electronics.

Last week GEC said it could be "weeks away" from a strategic alliance that could lead to a merger.

The company has been linked to both US defence companies like Lockheed and French electronics firm Thomson-CSF. A link with Lockheed could lead to a £25bn merger.

Merger fever is being driven by the need to make cost savings as defence orders have dried up since the Cold War ended.

Shares in BAe moved higher on the news to stand up 18p at 513p by 1235 GMT.

French objections

The merger of BAe and DASA, long advocated by Europe's defence ministers, has been held up by French objections. They want Aerospatiale, which is still state-owned, to be part of any deal. At the Franco-British summit on Friday, French Prime Minister Lionel Jospin appeared to remove that roadblock.

"People say there could be a merger of companies. We will accept that as a fact if it happens," he said.

Another problem is the future of Airbus, the highly successful commercial aircraft consortium, which is supposed to be turned into a commercial company in 1999. DASA and Aerospatiale each have a 37.9% share, with BAe owning 20%.

At an Airbus board meeting on Friday, Aerospatiale reportedly demanded that the combined BAe-DASA group reduce their share in Airbus to under 50%, giving Aerospatiale an equal share. DASA said that Aerospatiale was "taking Airbus hostage," but Aerospatiale denied that it wanted any more than confirmation of the rumour mergers.

Aerospatiale derives 70% of its sales from Airbus.

GEC: facing both ways

GEC, which has accumulated a cash mountain of £1.25bn, had been hoping to merge with BAe, but the DASA deal would put that on hold.

It has been considering a merger with France's largest electronics company, Thomson-CSF. The French would like that deal to counter the BAe-DASA tie-up, and have been reducing the government's state in Thomson to prepare it for a merger.

But it is concerned that such a move could jeopardise its lucrative US defence business. It has just paid $1.4bn for US defence contractor Tracor. The defence electronics business of Northrop Grumman is also up for grabs following the failure of that company to merge with Lockheed.

Some reports suggest that GEC is also talking to Lockheed Martin, the second largest US defence manufacturer, whose interests range from aircraft to missiles to space systems. That would create a huge company, with £25bn in sales.

Whatever the outcome of those talks, the architecture of Europe's defence industry is likely to look very different by the New Year.