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Amid national security concerns over investment ties with China, the Biden administration announced on August 9 a new proposed regime to scrutinize and ban some US investments into China that could help Beijing develop military technology. The administration publicly eschews a broad “decoupling” agenda in favor of what it says is a more narrow “derisking” of ties with a “small yard, high fence” for controls. This latest announcement fits that strategy well. An overly broad regime could be disastrous, necessitating a ballooning bureaucracy and expansion of government power that would bog down US investor firms with international business in red tape and disadvantage them against their peers abroad. As covered in an earlier PIIE blog with context on the outbound issue, its impact on China is likely to be muted, considering China’s large pool of available capital and the US government’s already formidable tools to restrict investment and transfer of technology to China.
No Broad Decoupling
Thankfully, the Treasury’s proposed rules following the new executive order are far from a herald of broad decoupling, striking a careful, sensible balance that hopefully will survive public comment. Until a final version takes effect, nothing changes immediately for investors, except that Treasury can now request information on, not block or unwind, new transactions to start gathering data. Instead, the proposal poses questions to the public on the key “what ifs” to refine what ultimately will be put in place. Unlike the Committee on Foreign Investment in the United States (CFIUS), which can review investment into US companies from any source, Treasury's rules would apply only to “countries of concern,” which for now includes just China, Hong Kong, and Macao. That, combined with careful carve-outs, should keep the spillovers to US allies and other countries minimal. One reason Treasury may have limited urgency is that investors have already begun adapting by being more careful with investments in sensitive sectors in China.
The proposed regime creates a relatively simple categorization of investments to China based on the investee’s activities in, for now, only a subset of three sensitive sectors. Some types of investments are prohibited (very narrow), others are allowed with reporting requirements (still quite narrow), and most are simply allowed with no new requirements or restrictions. Virtually all investment outside China and the vast majority of investment even into China would be in the latter category. This simplicity with bright lines should keep the program, the bureaucracy, and its costs lean, in contrast to CFIUS, which has much more expansive criteria of what constitutes a threat and has to perform a lengthy, resource-intensive case-by-case review of each investment that crosses its desk. The proposal focuses on capital likely to be accompanied by other benefits to the investee rather than just money, arguing that benefits like managerial expertise and access to networks also can boost Chinese capabilities crucial to national security.
Limited Impact
The order applies only to equity financing and debt that can convert to equity, as well as greenfield investment and joint ventures when they are likely to involve creation of a Chinese entity involved in sectors covered in the order. It would “exempt” a host of transactions like technology licensing or selling or buying materials (which would be under export controls’ jurisdiction) and routine capital flows between parent companies and their existing subsidiaries in China, even in covered sectors.
If the proposal is implemented with limited changes, the impact on actual investment flows will likely be quite small. Firstly, the set of technologies and goods that would make a Chinese firm developing them off limits to a US investor are narrow. The first technology category applies only to semiconductor electronic design automation (EDA) tools, design of advanced semiconductors, semiconductor manufacturing equipment, chip fabrication, and advanced packaging at thresholds overlapping with well-known export controls released on October 7, 2022, where the rationale to stop US capital and expertise helping China to innovate around existing controls is clear. The second, Quantum, is still a nascent category with strong links to security but limited commercial applications so far and a miniscule portion of total venture capital investment. Artificial Intelligence (AI) is much trickier to track down, but the proposed standard for bans on investment in AI firms is high, but only for software that is exclusively or mostly for military, mass surveillance, or intelligence applications.
Secondly, even the notification regime proposed in the executive order is narrow. Importantly, the proposal is less likely to chill investments because it suggests notification ex-post by 30 days after a deal closes, instead of requiring advanced notice that could lead Treasury to raise issues about an investment before it is completed. The notification requirement is broad only for semiconductors, covering most chip-related investments in technology not caught in the October 7, 2022 export controls. For AI, notification covers AI designed exclusively or primarily for use in a longer list of applications, including facial recognition (justifiably sensitive due to its use in places like Xinjiang) and control of robotic systems but does not seem to affect at first glance areas like autonomous vehicles. Treasury seems clearly uninterested in creating an onerous, broad reporting requirement for investments in China.
Thirdly, the proposal exempts from both prohibition and notification, under most circumstances, investments in publicly traded companies (these are already covered by another authority[1]), index funds, and limited partner investments in venture capital as long as these are truly minority, passive investments. These exemptions all make sense, as such investments are not likely to be accompanied by the flows of expertise the executive order is worried about. The order does, however, extend to subsidiaries of US companies and US persons[2] even when abroad, which would put US venture capitalists under its jurisdiction even if their funds are organized offshore. It does allow for example for a foreign firm with US executives to make prohibited investments under some circumstances if the US persons recuse themselves from the investment decision. It also allows US firms to fully buy out a Chinese firm’s assets or subsidiaries located outside China and in covered sectors.
Fourthly, the proposal includes a crucial provision to make compliance tractable and ensure that the order leaves all but a small subset of US investments in non-Chinese firms untouched. A firm whose subsidiaries are both Chinese and involved in the covered sectors only falls under the regime if more than 50 percent of its revenue, operating expenses, capital expenditure, or net income come from those subsidiaries. Thus, for example, an investment in a Korean chip firm that makes 40 percent of its chips in China through Chinese subsidiaries would not be prohibited (an investment in the Chinese subsidiary directly would). An investment in a Chinese conglomerate with small chip design operations for autonomous vehicles also would not be covered. Without this provision, it would be virtually impossible to determine whether investments in a sprawling Chinese conglomerate or non-Chinese firm with some Chinese operations should be implicated. Treasury will, however, need to be vigilant about Chinese measures like sham mergers between firms in sensitive sectors and non-sensitive sectors that could be designed to dilute the revenue share and fall under the 50 percent threshold. The order does ban any “action that evades [or] has the purpose of evading” the rules, so investors would take advantage of this “loophole” at their own risk.
One caveat is that the notification regime requires a long list of information on the investor, the transaction, and the investee, including information that would be highly sensitive in China: “products, services, research and development, business plans, and commercial and government relationships with a country of concern.” The proposal tries to ensure this information would be kept private, but firms will have legitimate concerns about whether such information could get them hauled in front of Congress and criticized for their investments or be used against them in some way by a future administration.
Positive Proposal, Uncertain Outlook
Considering the risks that the regime could have gone too far, the worst-case scenarios have been avoided for now. Treasury and the White House deserve credit for their careful work with this proposal. Yet many elements designed to keep the regime surgical have already been criticized as loopholes, so congressional action forcing a more expansive regime is a real possibility.
For now, the United States will be going alone with this initiative, though the G7 has agreed that “appropriate measures designed to address risks from outbound investment could be important to complement existing tools,” and both the United Kingdom and the European Union are considering their own proposals. Though the United States is dominant in venture capital, controls are less likely to be effective if they remain unilateral. Still, this compromise is an excellent start to a regime that is much more likely to expand, for better or for worse, than it is to contract in the future. Hopefully the balance is retained, both in the final proposal and in its future use.
Notes
1. The “Non-SDN Military-Industrial Complex Companies List,” also managed by Treasury, bans investment in publicly traded securities of firms labeled as aiding China’s military.
2. US persons mean any US citizen or permanent resident, wherever they live, and also anyone in the United States.
Data Disclosure
This publication does not include a replication package.
