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 such as 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]."

Most profitable region

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 percent 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 US$213 billion - 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.

"Europe is 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 percent 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."

Still, the problems of 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.

Despite the problems, Guillen does not see a complete disintegration of the eurozone, but rather the emergence of a system that has a looser affiliation for some of those weaker nations.

INSEAD's Fatas predicts the eurozone 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."

Regardless of whether the eurozone 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 eurozone 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 eurozone.

According to Wharton finance professor Franklin Allen, such steps are prudent. "[Companies] are worried that the eurozone will break down, even partially," he says. "If Spain decides to leave the eurozone - 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."

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 percent.

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.

The economic weakness in Europe is also hurting consumer products firms. Procter & Gamble (P&G) took a US$1.5 billion write down earlier this year on appliance and salon equipment businesses, in part due to weakness in the market in Western Europe, where 50 percent of the sales of those businesses are generated.

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.

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."

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 US$1 billion in China by 2015.

Difficult transition

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 percent of total global output and nearly 30 percent 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.

Adapted from Knowledge@Wharton. To read the original version, please visit: http://bit.ly/Jfi5OU