(FORTUNE Magazine) – IN THE 1990s, the battleground for leadership in the global auto industry will be not North America, not Asia -- but Western Europe. By overtaking the U.S. as the world's biggest market, Europe is generating huge profits for U.S. and European producers. But the joy ride is ending. The world's best automakers -- the Japanese -- are poised to attack. Says Lindsey Halstead, chairman of Ford of Europe: ''The Japanese will challenge the traditional market leaders and national champions. We're headed for an era of fierce competition.''

The struggle will test the European Community's resolve to open its markets after 1992. Autos have been among Europe's most protected products. Famous old names such as Fiat and Peugeot reflect more than a little national pride and identity. Carmakers in Italy and France in particular have flourished, and grown uncompetitive, in highly protected markets. Held back by national quotas, the Japanese have only 11% of the European market, compared with 25% in the U.S. Without such restraints, Japan's share in Europe could easily rise to 20%. Consider how well they have done in countries without import quotas: 40% of the market in Ireland, 25% in Sweden, 15% in West Germany. To fight the Japanese, U.S. and European carmakers are forming alliances that will create fewer but stronger companies. In December, Ford paid $2.5 billion for Britain's Jaguar, and General Motors spent $600 million for 50% of the auto division of Saab-Scania. Saab's Swedish rival, Volvo, is discussing some kind of alliance with Renault of France. The prize is the world's most attractive car market. Europe is setting sales records while the U.S. spins its wheels. Look at what happened from 1985 -- when the two markets were about even -- to 1989. Car sales jumped 26% to a record 13.4 million in Europe but fell 9.4% to ten million in the U.S. The combination of fast-rising income and low car ownership is especially prevalent in southern Europe. Since 1987, sales have soared 14% in Italy, 26% in Spain, and 47% in Portugal. As for the future, Toyota's European chief, Tsuyoshi Matsura, says, ''there is much more room for growth here than in the mature U.S. market.'' Car ownership in Europe runs 380 per 1,000 persons, vs. 580 per 1,000 in the U.S. With strong economies swelling their paychecks, European suburbanites are buying second and third cars. Europe's six full-range carmakers are all doing well and are remarkably well matched. Sandwiched between leader Fiat, with a market share of 14.9%, and sixth-ranked Renault with 10.4% are Volkswagen (14.8%), Peugeot (12.9%), Ford (11.9%), and General Motors (11%). Since the early 1980s, Fiat, Renault, and Peugeot have all rebounded from near-bankruptcy to post record profits. After running up $19 billion in losses from 1981 to 1986, Fiat expects to report a $3 billion profit for 1989 on sales of $41 billion. For GM and Ford, strong European earnings are offsetting weak performance at home. GM's operating margin is 16%, Ford's 13%. Says analyst John Lawson of Nomura Securities in London: ''The U.S. industry has not seen these levels of profitability in years.'' In 1990, European operations probably will contribute about 45% of Ford's profits and about 60% of GM's. GM Europe's net could rise some 10% to over $2.2 billion. Ford's earnings will probably not increase because of heavy spending on Jaguar. How deeply the Japanese should be allowed to penetrate this rich market, and how soon, is the subject of vigorous debate within the EC. France restricts Japanese cars to 3% of sales. Tough quotas in Italy and Spain hold Japan's share to less than 1%. Even free-market Britain sets a ceiling of 11%. The EC is committed to abolishing all national auto quotas eventually, and all member countries -- even those with quotas -- agree in principle. The argument is over timing. Says Peugeot's President Jacques Calvet: ''We must construct Europe for the benefit of the Europeans, not the Japanese.'' The EC is working out a compromise that would give European manufacturers temporary protection. During a transition period from 1993 to about 1997, Japanese producers would ''voluntarily'' limit their European market share. Unlike in the U.S., these restraints would apply both to imports and cars the Japanese make in their European plants. Though precise limits have not yet been set, the EC favors a plan that would allow the Japanese to increase their market share gradually during the transition. Thereafter, the EC insists, all restrictions would disappear. TO CALM CALLS for protectionism -- and avoid the EC's 10% tariff on auto imports -- the Japanese are expanding production in Europe. The most enthusiastic host is Britain, where Japan's Big Three automakers have pledged to spend $2.7 billion on new assembly plants by the late 1990s. The pioneer is Nissan Motor. Since 1986, Nissan has been assembling its midsize Bluebird at a factory the company built in Sunderland, a port city on the North Sea. In 1993 annual production will nearly triple to 200,000 cars. A Honda factory planned for Swindon, between London and Bristol, will turn out 100,000 autos a year by 1994. And Toyota will soon break ground in the rural Midlands for a plant that will make 200,000 cars annually by 1997. Mazda and Mitsubishi Motors are expected to follow shortly. Japanese production in Europe by 1998 could reach over one million cars a year. According to the Economist Intelligence Unit, a London research organization, car sales should rise almost 2% a year, increasing annual volume by 1.5 million units by 1998. Japanese cars pouring out of new European plants could absorb about 60% of the market's growth, leaving a relatively small increase for the Europeans. To compound the problem, the Europeans are the world's least efficient carmakers. A Massachusetts Institute of Technology study shows that Japanese factories in Japan and the U.S. need an average of about 19 man-hours to assemble a car. U.S. automakers producing in Europe can do the job in 31 hours, while Europeans need 36. Says Mark Noppe, director of assembly operations for Ford of Europe: ''The Japanese will definitely be the low-cost producers.'' Their hallmarks are a flexible work force, lean inventories, and a minimum of defects, thanks in part to cars that are designed for easy production. Nissan's new plant in Sunderland has all these features. By starting from scratch, Nissan has been able to build an ideal work force. Each of its 2,300 workers was selected from about 50 candidates. The average age is just 27, compared with 41 at Ford's plant in Cologne and 42 at Peugeot's in Sochaux, France. ''Younger workers have more physical dexterity and often more enthusiasm,'' says Jean-Louis Silvant, Peugeot's director of production. Nissan's British workers have plenty of enthusiasm, and they seem to love Nissan's egalitarian, gung-ho spirit. All employees, from the plant manager to production workers, wear identical blue uniforms -- often with a tie sporting the Nissan logo. A single dining room features steak and kidney pie, though there is sushi for visiting Japanese. Everyone parks in the same lot, and there are no assigned spaces near the door for executives. The day before Christmas, Nissan rented a local theme park for workers and their families. Absenteeism is running at 2.4%. It's 9% at Ford's plant in Dagenham, near London.

The average cost per production worker for Nissan, including pay and benefits, is $17,000 a year, or $13,000 less than at Renault's plants in France. All of Nissan's workers are represented by a single union, while Ford struggles with six and has little freedom to shift workers from one task to another. By contrast, a worker at Nissan may in a single week operate a welding machine, program a robot, drive a truck -- and sweep the floor. Nissan is working with European suppliers to minimize defects in components. The campaign has been so successful that the plant operates with three days of inventories of locally supplied parts. That's just one day more than Nissan manages in Japan. Ford's and Peugeot's plants carry about seven days of inventories. The Sunderland factory is already approaching the company's productivity level in Japan, says personnel director Peter Wickens, and managers hope to draw even when production hits full capacity in 1993. Since 1987, Nissan has raised its unit sales 22% in Britain by blitzing the market with eight fresh models, from an updated version of the sub-compact Sunny to a new luxury sedan, the Maxima. Nissan's bold strategy in Europe is part of a radical shift in corporate culture engineered by President Yukata Kume. Since taking over the once stodgy company in 1985, Kume, 68, has stressed speed and innovative design. As head of R&D and corporate planning in the early 1980s, he became convinced that Nissan could compete only by being much more responsive to customers' rapidly changing tastes. EUROPEAN CARMAKERS have made some strides in efficiency. In 1984, Fiat needed 107,700 employees to produce 1.4 million cars; this year it will make 2.3 million cars with 7,000 fewer workers. The amazing thing is how far the Europeans still have to go. After increasing productivity 50% since 1984, Peugeot President Calvet is pressing for another 50% improvement over the next five years. U.S. companies are more efficient but are also feeling the heat. Ford estimates that its plants in Europe are 50% to 60% less productive than plants in Japan. To catch up, the company plans to copy the Japanese when it retools in West Germany and Belgium to produce new versions of its compact Escort and upper-midsize Sierra models. Members of task forces are touring Japanese plants and will bring Japanese management methods back to Europe. Ford plans to adopt Japanese-style just-in-time parts delivery and give workers more freedom to plan daily tasks. Says Noppe: ''By using Japanese techniques, we should approach Japanese productivity by the late 1990s.'' In the past, European manufacturers -- especially Renault and Fiat -- were notorious for making flimsy, unreliable cars. Although quality is improving, the Japanese still have a wide lead. Last year the British Consumers' Association, which conducts product surveys, evaluated 35 recent models sold in Britain on such criteria as frequency of breakdowns and number of repairs. Four of the seven most reliable cars were Japanese: Nissan's Micra, Sunny, and Bluebird models, and the Toyota Corolla. To make sturdier cars, producers are putting pressure on their suppliers. Ford has established a new rating called Q-1 based on such criteria as efficiency of shipments and frequency of defects. Ford will stop buying parts from any plant that fails to achieve a Q-1 by 1993. So far, 400 of Ford's 1,600 suppliers have won the rating, but officials figure as many as 250 ultimately won't make the grade. Ford reckons that the Q-1 program could reduce parts defects by 50%. Europe's producers are slow in bringing out new models, and part of the problem is their pursuit of engineering perfection. On average, it takes the Europeans more than five years to develop a new model, vs. 3 1/2 years for the Japanese. In the 1990s carmakers will need fast reflexes to match the shifting sub-compact desires of consumers. But they are getting faster, especially GM, which sells under the name Vauxhall in Britain and Opel in the rest of Europe. Since the mid-1980s, GM has shortened its development cycle from more than five years to just over four. It plans to reach three years in the early 1990s, when it will begin designing replacements for its two best-selling models, the compact Kadett and sub-compact Corsa. The shorter development cycle will save hundreds of thousands of engineering hours, cutting GM's development costs by 20%, or $200 million per model. THE EUROPEAN automakers best positioned to fight the Japanese are GM, Ford, and Volkswagen. GM, the most profitable in Europe, is a lean producer. All its sub-compact Opel Corsas and Vauxhall Novas are made at a low-cost factory in Saragossa, Spain. GM has the largest market share in the Netherlands, Switzerland, and Denmark, and ranks second in Britain and West Germany. Its new Opel Vectra is a big success in the midsize category. Last year GM outraced all competitors by boosting sales 10% in Europe to 1.45 million cars. Ford's network of 8,000 dealers from Stockholm to Gibraltar is the strongest in Europe. It has the largest share of the British market -- and ranks among the top three in Germany, Sweden, and Ireland. Ford's strength is small cars. Last year, powered by a hot-selling new version of its tiny Fiesta, Ford lifted its market share in Europe from 11.4% to almost 12%. Volkswagen is tops in the wide-open West German market, and is also No. 1 in Belgium, Austria, and Switzerland. It recently redesigned the cars produced by SEAT, the Spanish automaker it bought in 1986. The company's attractive lineup of models ranges from the frisky Golf -- Europe's best-selling sub-compact -- to the sleek, high-priced Audi 100. Its weakness is low profitability. Hurt by high labor costs in West Germany, Volkswagen is moving production of its smallest car, the Polo, to Spain. Lower costs, coupled with broad geographic reach, should make Volkswagen an even more potent competitor in the 1990s. Prospects are cloudier for Fiat and Peugeot. Despite striking sales gains, they remain far too dependent on their protected home markets. Fiat sells 68% of its cars in Italy, Peugeot 43% in France. Both companies are striving to broaden their appeal. Fiat, which also owns Lancia and Alfa-Romeo, is designing its new cars with an eye to foreign markets. The Tipo, a stylish compact introduced in 1989, is a big hit in northern Europe. Peugeot is the only company in Europe that markets two full-range brands -- the solid, reliable Peugeot and the technically avant-garde Citroen. They yield big economies of scale. Peugeot saved about 30% on development costs by coordinating design and engineering of its two new luxury cars, the Peugeot 605 and Citroen XM. Two best-selling sub-compacts, the Peugeot 205 and Citroen AX, are boosting exports. Still, Fiat and Peugeot need to do even better in foreign markets to compensate for share they are bound to lose to the Japanese at home when market restraints eventually are removed. MOST VULNERABLE is Renault, despite record profits of $1.6 billion in 1989. The state-owned company sells about 90% of its cars in France and other highly protected markets. Financially, it is the weakest of the big automakers. Heavily subsidized by the French government, Renault still has a debt-to- equity ratio of 2 to 1, which is six times the level at Volkswagen. Its solid but unexciting cars do not appeal nearly as much to non-French buyers as Peugeot's trendier models. Renault has much to gain from an alliance with Volvo. Earlier talks of merger collapsed, but some kind of partnership for developing new models and manufacturing components is likely. ''I won't rule out anything,'' says Paul Perci du Sert, Renault's director of marketing. ''But we don't want a merger. We want to develop cars together.'' Collaborating with Volvo would bolster Renault's weak position in luxury cars. Unlike Volkswagen and Fiat, which market deluxe cars under the Audi and Lancia brands, Renault lacks a luxury nameplate -- and hence a distinct image for its upscale cars. Its high-priced R-25, a flop outside France, sits in showrooms beside its plebeian subcompact, the R-5. Renault would love to market the successor to the R-25 in the early 1990s as a Volvo. The collaboration would also suit Volvo. Despite its cachet as a maker of high-quality family cars, Volvo is too small to stay totally independent. It badly needs a partner to share the $255 million cost of replacing its 200 series, the aging fleet of family cars. Ford's yen for Jaguar mirrors Renault's attraction to Volvo. Ford has long been tempted by the lucrative, fast-growing luxury-car market dominated by Germany's BMW and Daimler-Benz. But it ran up against the same roadblock as Renault: lack of a luxury brand. Tainted by Ford's small-car image, the $28,000 Scorpio is a dud. ''It's hard to sell up-scale cars under the Ford nameplate,'' says Rudy Boniface, Ford's sales chief for for southern Europe. Hard times at Jaguar helped Ford to land one of the world's most prestigious brands. Jaguar's problems stem from its heavy reliance on the U.S. market. In the late 1980s, U.S. sales plummeted with the dollar, cutting earnings from $87 million in 1986 to less than $10 million last year. Jaguar lacks the capital to produce a range of new models. It is also a weak manufacturer. At Jaguar's antiquated plant near London, it takes an incredible 100 man-hours to produce a single car, compared with an average of 35 at luxury-car plants in the U.S. Ford has ambitious plans for Jaguar. The XJ-6, an elegant sedan adorned with burled walnut and soft leather that starts at $39,500 in the U.S., is Jaguar's staple. Ford wants to create the British BMW, a volume producer of costly cars. The plan is to expand Jaguar's model range to compete in the lucrative, fast-growing $30,000-$40,000 executive-car class with the BMW 3 series and the Mercedes 190. To take on the Germans, Ford plans to invest more than $1 billion and triple annual sales to 150,000 units by the late 1990s. Says Bruce Blythe, director of strategic planning for Ford of Europe: ''As Europeans get older and wealthier, all of the factors that caused BMW to grow are accelerating.'' Lured by those high stakes, producers from three continents are revving up for the big race. The Japanese have cars to push into the lead. But a late surge could put the Yanks and Europeans back in contention.