New rules curbing US investment in China will be tricky to implement

Under mounting pressure to clarify economic and security policies toward China, President Joseph R. Biden Jr.’s administration dispatched two top emissaries in recent weeks to assert that the United States does not seek to “decouple” from China. But the speeches of Treasury Secretary Janet Yellen and National Security Adviser Jake Sullivan left myriad questions unanswered—most specifically, how Washington will curb technology transfers and investments to China without alarming legitimate investors and disrupting the world’s trading system.

Sullivan, in extensive remarks at the Brookings Institution on April 27, echoed Yellen’s comments, saying that Washington does not seek to impede China’s economic prosperity, only to protect US national security. He denied that the US aims to impose a “technology blockade” and is “narrowly focused on technology that could tilt the military balance.” But he invoked concerns over China’s military and political ambitions to justify building new tools and beefing up old ones to curtail trade and investment activity with China deemed as a threat to US national security.

Many investors and other observers were anticipating that Sullivan and Yellen would outline details of a new, highly controversial tool in the works that would restrict certain US investments in China in specific sensitive technologies with significant national security implications. The fact that they left the description of these tools vague seemed to reflect that the administration is having a challenging time balancing the planned restrictions against the concerns of a private sector that continues to have a stake in Chinese investments.

Apparently to reassure those concerned that the impending order might go too far, dramatically expanding government authority over US firms’ overseas activity in ways that would put them at a competitive disadvantage, Yellen said the new rules will be “narrowly scoped and targeted to clear objectives.”

But to avoid major unintended consequences, any such regime will need to be carefully crafted and focused on a few critical technologies. A broader data gathering component can be added to enhance understanding of remaining risks that the regime could cover if necessary. Ideally, the planned announcement could help placate both those who argue new authority is needed to limit US investments in China and detractors concerned about undermining US business.

Loopholes to Close?

New curbs on investment in China would be the latest salvo in mounting US-China economic hostilities. Congress has, for example, strengthened the Committee on Foreign Investment in the United States (CFIUS) and also created authority to scrutinize some of US firms’ overseas investments. But CFIUS only covers investment in the US.

Accordingly, in 2018, Congress overhauled the systems screening investments into the United States and controlling exports of goods and technology, primarily to address concerns about China. The Trump administration also created new authorities to block investments into companies involved with China’s military. Going further, the Biden administration announced sweeping export controls to China last October on sensitive technologies, cutting off China’s ability to buy advanced chips and chipmaking equipment.

In addition, the Biden administration built a “guardrail” into the CHIPS Act, which limits the investments that recipients of subsidies can make in China. An executive order issued by Trump in 2020 bars US individuals and firms from investing in publicly traded securities of firms the US Treasury has added to the Chinese Military Companies (CMC) List to ensure American money does not support China’s military modernization.

Another tool being deployed is financial sanctions on the Treasury’s “specially designated nationals” list. Commercial transactions with entities on the list risks punishment of being shut out from much of the global financial system. It is more of a nuclear weapon used sparingly so far against China, but there are now proposals to apply it to companies like Huawei.

The US Commerce Department’s export controls do not regulate flows of capital per se, but they regulate what data, blueprints, technology, and even knowhow is transferred to foreign individuals[1] whether in the United States or abroad. These controls also forbid US persons and companies helping China develop advanced semiconductors. There are gaps in these nets. The list of CMCs leaves private equity investments into startups untouched, and an entity by entity listing can lead to a game of whack a mole.

Defining outward investment has been challenging.

The Biden administration and a bipartisan group in Congress have had trouble reaching consensus on the objectives, scope, and design of outward investment controls. An effort by Senators John Cornyn (R-TX) and Robert Casey (D-PA) to get congressional backing for their proposed National Critical Capabilities Defense Act (NCCDA) fell short over concerns that their measure was too broad. Efforts by the Biden administration to consult with the private sector and other experts have been inconclusive so far. No draft rule has been issued for public debate.

Media reports suggest that an impending executive order will start small to restrict US investment in advanced semiconductors, quantum computing, and some types of artificial intelligence related to military and surveillance, but it is not clear what types of investments by US firms and individuals could fall under the new regime. The order must address whether the following should be affected:

• Investments in publicly listed Chinese firms by individuals and funds.
• Investments in startups by venture capital and private equity funds. These could target the general partner who manages the fund and its investments or the many limited partners who invest their own money but do not manage the fund.
• Direct investments by US firms, for example in research and development or production facilities in China, either on their own or as a joint venture with a Chinese partner.
• Actions by subsidiaries of US companies, or US subsidiaries of foreign companies.

Also unclear is whether the order will list sectors with straightforward prohibitions for investment or form a CFIUS-like review body to approve, modify, or reject deals. Equally complex is the question of what is “American” and what is “Chinese.” These definitions are not simple. American firms have subsidiaries and joint ventures all over the world, including in China, and many US investment funds are registered in offshore financial centers, with funds raised from investors all over the world, even if they are run through New York. Chinese firms also have large overseas presences, and Chinese nationals can be part of teams launching startups in Silicon Valley. Peter Harrell, a former Biden administration official formulating the regime said that “novel policy, legal, and resourcing issues” risk large “unintended consequences.”

The US government must finally decide whether its primary concern is with the effects of capital or knowhow/technology transfer. If it is capital, the impact on China will be small. China’s venture capital sector was managing around $280 billion at the end of 2019, compared to $403 billion in the US. A recent report from the Center for Security and Emerging Technology found that only 37 percent of fundraising rounds by value for Chinese AI companies included any US investor. Clearly, Chinese AI firms and presumably also tech startups in other sectors do not rely on US capital.[2]

Problems with Allies

The US will be mostly alone in having such a regime. Among the OECD countries, only Korea and Japan have outbound investment review/restriction regimes, and both are narrowly targeted. Korea’s is like the CHIPS Act guardrails in that they only apply to firms with “national core technology developed with government subsidies for research and development,” and Japan’s list of industries covered includes only weapons, leather, and narcotics. The European Union has made positive signals about considering an outbound regime but is unlikely to impose one in the near term.

Even if the new regime begins with a narrow scope, expectations that it will expand in the future could jeopardize US status as a financial center if investors flee to avoid risks posed by the new regime or because of red tape around investing in in China.[3]

Restrictions on US investment should recognize that whatever security benefit is gained from withholding financial knowhow and international recognition from Chinese tech firms may be offset by the potential benefit of having Americans learn from Chinese tech companies they invest in, many of which are at or near the top of their fields in technology. There are legitimate concerns about investments in sensitive technology in China, and there is a good case for a moral stance keeping US investors from funding technology in China that contributes to human rights abuses or military modernization. Still, policymakers should be aware that the effect of these controls may be limited. Previous prohibitions on US investors provide a sobering example. The US added SenseTime, one of China’s top AI companies, to the CMC list after it was linked with using facial recognition to profile Uighurs in China. It was already on the export blacklist. But the ban on US investor participation only delayed SenseTime’s Hong Kong IPO one week. Beijing had to raise the share bought by state-linked firms, but the deal went ahead without even a lower price.

Yellen’s statement suggests the US will rightly start small to avoid unintended consequences and gather data to understand the extent and channels through which US investment is entering sensitive sectors in China. These data can then inform a more careful diagnosis and tailored design for investment screening or prohibition. Whatever Washington decides, its rules could remake the US government’s relationship with its firms, investors, and the world.

Notes

1. Permanent residents are exempt.

2. Data limitations meant CSET could not find out each investor’s share in each fundraising round. The 37 percent of fundraising rounds by value involving US investors is thus a ceiling far higher than the actual share of US investors, because 80 percent of the time that a US investor was in a fundraising round, a Chinese or third country investor also contributed capital to that round. Only 7 percent of the capital raised came from rounds only with US investors. 

3. Edward M. Graham and David M. Marchick found this in their book on national security and FDI, in which the initial years of CFIUS led to large filing volumes that died down after the screening regime’s boundaries became clearer.