*[This article was originally published by Knowledge@Wharton on April 25, 2012.]

Why euro zone woes are creating headwinds for global firms.

Europe is in crisis — and that has major implications for multinational firms with significant operations in the region. In fact, while much is written about the race by corporations to penetrate emerging markets like China and Brazil, the reality is that the investment by multinationals in Europe dwarfs the assets they have in those fast-growing economies. And the sovereign debt crisis in Europe, along with weak economic growth, is sparking changes in how these firms operate — altering everything from manufacturing strategies to marketing to financial maneuvers.

“In the same way that European firms can’t do without the American market, Europe is a very important market for US multinationals,” says Mauro Guillen, a Wharton management professor. “But Europe is in recession, and American firms that have been there a long time are trying to become more efficient and rethinking [how they operate there].”

US multinationals in particular have a tremendous amount at stake in Europe. According to a report published by the Center for Transatlantic Relations, over the last decade more than half of US global foreign direct investment has gone to Europe. In the first nine months of 2011, US investment in all the BRIC nations was 6.1% of the investment made in Europe. And US direct investment in Ireland between 2000 and the third quarter of 2011 was more than 4.5 times greater than the investment in China during that period. Europe remains the most profitable region of the world for US companies, with 2011 US affiliate income from Europe hitting $213bn — nearly double earnings from South America and Asia combined. “It is a myth that all this money and capital leaving the US is heading to low cost labor” in emerging markets, says Joseph Quinlan, managing director and chief market strategist at US Trust-Bank of America Private Wealth Management. “US companies are in Europe to sell products and to leverage highly skilled labor.”

At the same time, the evolution of the US economy has made Europe a preferred investment location for US multinational firms, according to Heather Berry, a senior fellow at Wharton’s Mack Center for Technological Innovation and a professor of international business at the George Washington University School of Business. “As the US economy has shifted toward high technology services and financial industries, the foreign investment of US firms has also focused on high tech, finance and service industries located in highly developed countries with advanced infrastructure and communications systems,” she says.

“Europe is very crucial…. There are sophisticated customers and a lot of innovation there,” notes Wharton management professor Felipe Monteiro. “American investments in Europe have deep roots. When we started to see multinational investment, it started among developed countries — US multinationals investing in Europe and Japan. We have a well established flow of trade and capital between the developed countries.”

“The European Union is the largest economy in the world, representing more than 25% of the world’s GDP and demand — about twice as large as China,” says INSEAD professor of European studies and economics Antonio Fatas. “You cannot ignore the largest economy in the world.” Adds Quinlan: “People may think it is the old world and it doesn’t matter. But in 2011, we woke up to the fact that Europe does matter.”

Fixing the Unfixable?

The pain in Europe, of course, is not being experienced equally. “Germany is not growing quickly, but it has avoided a double-dip recession,” says Guillen. “But in Ireland, for example, the economy has contracted by over 20%. And France — while it’s not a basket case, it’s not Germany, either.” Meanwhile, Italy and Spain have slid back into recession, and today the UK also announced it has returned to recession.

Berry notes that US multinationals have the bulk of their investments in the stronger nations of Europe. “Of the European investment by US multinationals, more than 70% has been invested in the Netherlands, the United Kingdom, Luxembourg, Switzerland and Germany,” she says. “Those countries that have been hardest hit by the euro zone recession –including Greece, Italy, Portugal and Spain — together represent less than 7% of the total FDI investment by US multinationals.”

Still, the problems of those weak countries are dampening growth elsewhere in Europe. Moreover, the push by the stronger nations for fiscal austerity in the weaker countries is likely to exacerbate the downturn. “What we need is some inflation,” says Wharton management professor Olivier Chatain. “But politically, the response has been one of austerity, which, if it is implemented in the way it is now outlined, will be self defeating. In the case of Spain, they want to reduce the deficit as a percentage of GDP — so they cut the budget. But when you do that, GDP goes down further.” As a result, Chatain sees a protracted period of difficulty in Europe. “My gut feeling is that we will see five to 10 years of very slow growth with very gradual and painful institutional changes.”

That outlook raises the prospect that the euro zone will not hold together. “There are more and more voices saying ‘We are trying to fix a problem that maybe isn’t easy to fix or that shouldn’t be fixed,'” says Guillen. “You have a number of countries on the periphery that are having a lot of trouble. In the past, those countries would have devalued their [own] currencies to make themselves competitive. The problem is, how can you make a block of 27 countries with very different levels of competitiveness work?”

Despite those issues, Guillen does not see a complete disintegration of the euro zone, but rather the emergence of a system that has a looser affiliation for some of those weaker nations. “I don’t think the whole system of the euro will fall apart. But sooner or later, they will have some solution that results in a core group of countries remaining essentially a ‘hard’ and ‘soft’ euro zone. I don’t see how you can remain within the same monetary area when you have such disparities in economic performance.”

INSEAD’s Fatas predicts the euro zone will emerge intact. “There is a small chance that some countries, Greece in particular, will abandon the euro area,” he says. “But I cannot imagine at this point a large number of countries leaving the euro, and even less a disappearance of the euro as a currency. The main reason is that as much as the crisis is posing challenges to the euro countries, adding currencies will not solve those problems. To a large extent, what countries like Spain are going through is identical to what the US economy has gone through: a large asset price bubble focused on real estate that has led to a deep financial crisis. Changes in the exchange rate are not a magical tool to deal with this situation.”

Protective Measures

Regardless of whether the euro zone holds together completely, firms are looking to protect themselves from a breakdown. According to The Wall Street Journal, drug maker GlaxoSmithKline (GSK) has been moving cash at the end of each business day from the euro zone to banks in the UK. At the same time, GSK is trying to accelerate the collection of money owed to it by parties in the euro zone. According to Wharton finance professor Franklin Allen, such steps are prudent. “[Companies] are worried that the euro zone will break down, even partially,” he says. “If Spain decides to leave the euro zone — a low probability right now — deposits in Spanish banks will be translated into the new currency and will be worth much less than they were when they were denominated in euros. Firms could lose massive amounts of money. We saw this sort of thing play out in Argentina in 2000.”

That risk has far reaching implications. “Companies have to look very carefully at the risks they take,” Allen notes. “So how should they write contracts? Should they include clauses so that in the event a country leaves the euro zone, they are still paid in euros?”

Just as daunting are the challenges of operating in the face of a recession and weak consumer confidence. Guillen notes that makers of durable goods — autos in particular — are among the hardest hit. “They are really suffering. People need to eat and buy clothes, but they can postpone buying an automobile.” The Center for Automotive Research is projecting that car sales in Europe this year will contract 5%.

The result is that automakers in Europe — both domestic firms and the foreign affiliates of the Big Three auto manufacturers in the US — are facing significant overcapacity. At the Geneva Auto Show in March, there was much discussion about the likelihood of major restructuring and plant closings in Europe. Certainly, political issues make plant closings difficult in Europe, but auto executives have been warning they are inevitable. General Motors, for example, has said it is considering options to improve performance at its money-losing European Opel unit. The company has already trimmed its European work force by 5,800 and closed a plant in Belgium.

US automakers aren’t the only ones looking to take costs out of European operations. In April, Japan’s Mitsubishi Heavy Industries announced a restructuring of its forklift truck production in Europe, a step it attributed to “Europe’s lackluster forklift market stemming from the deepening debt crisis in the euro zone and other factors.” The economic weakness in Europe is also hurting consumer products firms. Procter & Gamble (P&G) took a $1.5bn write down earlier this year on appliance and salon equipment businesses, in part due to weakness in the market in Western Europe, where 50% of the sales of those businesses are generated. And in February, P&G announced a $10bn cost cutting program due to weak growth in developed markets such as Europe.

But firms will need to do more than cut costs to make the European market more profitable. Take the case of Starbucks. The coffee marketer has seen disappointing performance in Europe compared to its dominance in the US — and austerity measures in some countries have amplified the problem. Now, Starbucks is looking to revitalize its European stores, in part by better tailoring its products to local tastes. Among the additions: a foie gras sandwich in France and stronger lattes in the UK

Regardless of sector, companies will continue to search for ways to maintain a foothold in the region. “When you think about the contribution Europe makes for multinationals, it is not trivial,” says Kannan Ramaswamy, management professor at Thunderbird School of Global Management. “Firms need to hold on to that mature, valuable existing market.” Wharton’s Monteiro agrees. “Companies won’t close their [operations] there and leave,” he says, echoing the notion that there is a “huge variance” in the level of crisis between countries in Europe. “When you are in a crisis like this, you have to be as efficient as you can. I think multinationals might look at the variance among different counties so that those [operations] that are less efficient are brought into line with the more efficient.”

Looking East

While improving operations in Europe will be critical, the current crisis only ups the stakes when it comes to penetrating fast-growing markets, including China. “It goes without saying that Europe will become less important, relatively speaking,” says Wharton’s Guillen. “We are seeing a dramatic reconfiguration of consumer markets and economic activity around the world.” Chatain agrees. “If you are specializing in something that is very high end, a luxury, there will be more growth in China and Brazil, where you have a whole layer of the population that is growing very rich.”

P&G is one example: While the company is cutting costs overall, it is upping its investment in rapidly expanding consumer markets. The firm has outlined plans to open 20 new plants in countries like Brazil and China, including a massive new facility in Luogang, Guangzhou. All told, P&G is expected to invest as much as $1bn in China by 2015.

But for many firms, making that transition will be difficult. “[Multinationals] have been talking a good game about shifting focus to emerging markets, but many have not followed through,” says Ramaswamy. “They may not have enough on-the-ground expertise [in those markets]. Plus, they may suffer from a need for control — so they want to implement their strategy in [a] market with little local input. That is the key reason they have been unsuccessful. I really doubt whether many … multinationals will be able to make that switch to emerging markets quickly.”

Even if they are successful in building up share in emerging markets, multinationals will be far from insulated from the challenges facing Europe. Guillen co-authored a recent op-ed in which he noted that Europe’s problems could clip the growth of even the fastest growing economies. “A European recession will affect the global economy as a whole,” Guillen wrote. “The European Union represents some 25% of total global output and nearly 30% of consumption. Countries that export manufactured goods or natural resources will suffer slower demand and possibly falling prices.” For multinationals, Guillen and other experts predict, the fallout from the European crisis is likely to be felt around the globe.

*[This article was originally published by Knowledge@Wharton on April 25, 2012.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.