> With Sino-U.S. security competition intensifying, Washington will continue to tighten measures aimed at limiting Chinese access to critical U.S. technology, including outbound investment restrictions. At a minimum, Washington will expect its allies not to undermine its policies; more likely, it will increase the pressure for its allies to fall in line.
> Germany should therefore push more forcefully for an integrated EU policy on outbound investment (as well as export control and inward investment policies) to help strengthen its position in negotiations with Washington and to enhance its ability to nudge Washington towards narrower restrictions in exchange for helping to make them more efficacious. A failure to reach agreement may lead Washington to implement “secondary” measures that will negatively affect German and European economic interests.
See also: Restricting Technology Leakage
In a conflictual geopolitical environment, economic interdependence gives rise to economic and political vulnerabilities, or what might be called an “economic security dilemma”. Geopolitical competition leads governments to put less emphasis on absolute economic gains and more emphasis on both relative economic advantage and national security. By imposing selective restrictions on cross-border trade and financial flows, governments seek to mitigate their own economic vulnerabilities, exploit others’ vulnerabilities and generate relative economic and national security gains.
Technology diffusion – a major source of national and international prosperity – is dependent on the relatively unrestricted flow of cross-border trade and financial. But advanced technology can also enhance a country’s relative military power and strengthen its economic advantage. And to the extent that one country depends on another country’s technology, it also confers power to the latter. National security considerations and the quest for relative economic advantage therefore provide a rationale for restricting technological leakageto geopolitical competitors, while they do not do so for restricting technological diffusion to its members. [1]
There may be a further a rationale for governments to intervene. Not only do the economic interests of a country’s tech companies often diverge from the broader national security interests as defined by the government – what is good for GM is not necessarily good for America – but companies’ focus on short-term profitability, which may make them more willing to trade market access for (forced) technology transfer may not be in their longer-term commercial interest. Selective restrictions may help companies overcome this dilemma.
Nonetheless, restricting technological diffusion through export controls and restrictions on inward and outward investment have economic and political costs. Imposing tech transfer restrictions limits the economies of scale of and the profitability of domestic technology companies (and their ability to finance research and development); it may reduce domestic competition and stifle domestic technological innovation; it may lead other countries to retaliate by imposing reciprocal restrictions on trade and investment, hurting supply chains and access to critical technology, causing additional costs; it may induce other countries to seek technological autonomy, which, if successful, eliminates technological dependence and reduces geo-economic leverage.
Next to export control and inward investment policies, outbound investment policy is a crucial instrument in managing the cross-border flow of technology. This policy brief will discuss what factors should inform the design and implementation of an outbound investment.[2]This is a complex task involving important economic and political trade-offs and a detailed understanding of how investment can facilitate technology leakage. This is all the more for a country like Germany that relies on advanced technology exports and is highly dependent on cross-border trade and investment, and particularly with respect to China, the country that will be the primary focus of the new outbound policy in the context of the German government’s recently released National Security and China strategies.[3]
Designing an Outbound Investment Policy
Identify existing and emerging (future) technologies critical to national security and economic-technological leadership. A determination needs to be made which technologies are critical with respect to national security and which are important to economic-technological leadership. In many instances, there will be an overlap. Much depends, of course, on how extensively national security is defined. Technologies should be scored in terms of their present and future potential to affect national security and technological-economic leadership (comprising national competitiveness and productivity). The government should establish a scientific advisory council and consult widely to evaluate the potential of existing and particularly emerging and foundational technologies. Scores should be continuously re-assessed.
Take into account the complex cost-benefit trade-off involving national security and economic leadership. If, for example, a technology has the potential to confer critical and long-lasting military advantage, restrictions should be tighter and higher economic costs will be acceptable. But if a technology is assessed to confer only a temporary economic advantage, restrictions should be limited and associated costs should be kept to a minimum. The cases of short-term military advantage and long-lasting commercial advantage fall in between the above options in terms of the economist cost versus national security benefits and economic leadership trade-off. Determining the (economic) costs and (economic/ military) benefits involves a complex and to some extent uncertain assessment. It will be easier with respect to existing than emerging technologies.
Restrictions should be effective (and efficacious). A measure is effective if investment restrictions curtail the transfer of national technology at the level desired, but they are efficacious if they also help preserve technological advantage. Restricting technology-focused investment restrictions may be effective in terms of preventing another country from accessing indigenous technology on the back of cross-border financial flows. But it may be inefficacious because the country may be able to source the technology from elsewhere or because it leads the country to successfully reverse-engineer existing technology or make greater efforts to pursue emerging technologies. (As will be discussed below, efficacy often requires multilateral cooperation.)
Determine what types of cross-border investment create risks of technological leakage and design rules accordingly. Overseas investment in technology companies is accompanied by financing and, often, so-called intangibles. The financing aspect is far less relevant, particularly in the case of China, which has the ability to direct massive resources in support of technological innovation. More important as far as technology leakage is concerned are the intangibles that accompany investment, such as access to knowledge and capabilities, technological cooperation, greater visibility, access to investors, access to networks and markets and managerial expertise. Investment restrictions should therefore target the transfer of intangibles. At risk of over-generalization, measures should be focused on activist rather than passive investment; they should be more focused on equity investment than debt; and they should focus on more opaque private markets, including private equity, venture capital and joint ventures, rather than public markets. This is so because the incentives to provide intangibles are greater for equity and activist investment than for debt and passive due the greater financial upside (generally) associated with the former compared to the latter.
Prepare for potential countermeasures by countries affected by technology-focused investment restrictions. Restrictions, particularly if they target specific countries, may lead to retaliation and reciprocal restrictions, targeting technological dependencies. They may also target a country’s geo-economic vulnerability more broadly, including trade or its foreign investment. The German government should assess the nature and costs of potential retaliation and take risk mitigation measures. The greatest vulnerabilities arises, as recent events have shown, from restrictions pertaining to difficult-to-substitute, critical goods, services and technology. The possibility of retaliation should be factored into the cost-benefit assessment discussed above.
Outbound investment policy must form part of a broader, coordinated national economic security strategy. Outbound investment policies will only be effective in terms of limiting technological diffusion if they are part and parcel of a broader array of policies, including inward investment restrictions and export control policies rules. It naturally makes little sense to deny another country access to critical technologies if the country can simply purchase the technology due to a lack of export control measures or inward investment restrictions. Measures also need to include technology transfer licensing and restrictions on the ability of nationals to work for restricted foreign technology companies. Outbound investment screening needs to be integrated with other foreign economic policies to be maximally effective. Otherwise there is a risk that a country is settled with the economic costs of technology restrictions but none of the assessed benefits.
Strengthen defenses against industrial espionage. Because technology restrictions will increase the economic and financial returns on acquiring critical technology in “non-economic”, illegal ways, it is important to strengthen defences against industrial espionage among national companies developing and producing critical technologies, whether they are located at home or abroad. Defenses should be strong enough to defend against sophisticated, state-sponsored cyber espionage. Here the government has a role to play in terms of supporting corporate cyber-capabilities as well as the sharing foreign and counter-intelligence.
Outbound investment policies should be integrated at the EU level. The harmonization of EU member policies, already proposed and strongly supported by the European Commission, is highly desirable. It increases the efficacy of outbound investment policies; it strengthens the role of the EU in negotiating coordinated policies with third countries (see next paragraph); it helps prevent free-riding and it may help deter third-country retaliation. The challenge will be to convince member states with a small technological base to forego the financial upside of foreign technology investment. Similarly, EU countries that are less immediately concerned about national security will have lesser incentives to go along with an integrated EU policy. The EU has in recent years managed to adapt various geo-economic deterrence and defense policies aimed at deterring geo-economic coercion. It has also pushed for greater coordination of export control and inward investment policies.
Germany (and the EU) should coordinate its outbound policies with the United States to make the policy more efficacious in terms of preventing technology leakage and minimizing the risk of transatlantic technology fragmentation. A common transatlantic approach makes restrictions more efficacious. The EU is committed to de-risking and Germany has committed to exploring cooperation on an outbound investment regime at the G7 meeting in Hiroshima. In principle, Germany and the United States share similar concerns about technological leadership. However, different levels of international economic dependence and different levels of security competition create different levels of incentives to tighten technology transfer, particularly vis-à-vis China. Being more directly affected by geopolitical and military competition with China and being economically less vulnerable to Chinese geo-economic retaliation, Washington has been substantially more forward-leaning than Germany and Europe. The fact that Washington has not shied away from from putting pressure on allies to fall into line with U.S. policy (e.g. export controls) shows how serious Washington takes the issue. The EU-US Trade and Technology Council is a forum where such coordination should be hammered out. If this fails, and little has come out of the bi-annual meeting, it may be necessary to move the issue of outbound investment (as well as export control and inward investment) coordination to the level of heads of government.
New U.S. Outbound Investment Review Mechanism
Washington views technology as a key domain of geopolitical competition and has tightened restrictions on technology exports[4] and inward foreign direct investment in critical sectors [5] on several occasions in recent year. The Biden administration has for the first time issued a decree that regulates and restricts U.S. outbound investment.[6] Sanctions-related financial restrictions targeting certain Chinese entities already existed[7]. A regime that restricts financial investment in another country’s technology sector has never existed before.
The new policy establishes, for now, a relatively light-touch approach. [8] Treasury is currently working out the precise details, but the decree will “prohibit or require notification” of investments by U.S. persons in three high-tech sectors (semi-conductors, artificial intelligence and quantum information technology) in, or related to, “countries of concern” (China, Hong Kong, Macao). Treasury will have no authority to block or unwind past transactions.
The decree prohibits equity investments and debt that is convertible into equity stakes, greenfield investment and joint venture in these sectors. Investment in publicly-listed companies, index funds, mutual funds, exchange-traded funds and other types of passive investment, including limited partnership investment and venture capital as long as these investment are minority stakes only, will not be restricted. But US subsidiaries in China as well as venture capital investment, even if organized offshore, will be subject to restrictions. Restrictions will mainly apply to private equity investors and venture capital funds as well as U.S. investors in joint ventures with Chinese firms (wherever they may be located). The decree will also prohibit investment in third-country entities that invest in China in the covered sectors as well as U.S. persons working for foreign entities involved in directing covered investment in the three covered sectors.
Prepare for a further tightening of U.S. technology-related restrictions, including outbound investment
Rhetoric notwithstanding, U.S. policies seek to preserve and enhance America’s lead in critical technologies vis-à-vis China. [9] This makes sense given that emerging technologies are closely linked to national security. Besides, economic productivity I sa critical long-term factor affecting geopolitical competitiveness.[10]
Despite the high degree of polarization in Washington, hawkish China policies – more so than hawkish Russian policies – enjoy broad bipartisan support and the administration will face little opposition from Congress if decides to further tighten outbound investment, inward investment or export control policy.
There is disagreement within the administration as to how extensive restrictions should be, pitting national security folks (National Security Council, Defense Department) against Treasury, with the Commerce Department, which oversees export control policy, landing somewhere in between the two sides. The U.S. business community remains, by and large, opposed to restrictions, whether they apply to trade or investment.
But the administration has nevertheless sufficient leeway if it feels the need to tighten restrictions further. The recent tightening of export control and inward investment policies as well as the establishment of an outbound investment regime has all been done via executive decrees, leaning on the International Emergency Economic Powers Act.[11] The Senate is also pushing for a wider sectoral coverage and the House, and unsurprisingly, and more particularly the Select Committee on Strategic Competition between the United States and the Communist Party, is hawkish with respect to any types of investment in China, including passive investment by large U.S. financial companies. The reality is that parts of Congress are more hawkish the administration.
Therefore, ss geopolitical competition intensifies, Washington will further tighten restrictions related to technology exports and technology-related financial flows, including both in- and outflows. And where U.S. policies require multilateralization to be sufficiently efficacious, Washington will seek the cooperation and support of its major allies in Europe and Asia. If transatlantic cooperation and coordination cannot be reached, Washington will tune up the pressure for its allies to fall into line. Washington, and particularly U.S. Congress will not find it acceptable if allies take advantage of commercial opportunities that open up as a consequence of U.S. restrictions. Washington will then likely restrict foreign companies’ and investors’ access to the U.S. market and technology if they fall afoul of U.S. restrictions. This represents significant risks for German and European companies, which continue to rely not only on the U.S. market but also on American emerging technology.
Germany should push for a more integrated policy at the EU level and engage Washington more forcefully on coordinating outbound investment policies, particularly before U.S. restrictions become tighter, possibly including the unwinding of investments, which may, directly or indirectly, negatively affect German investment in China. For now, U.S. rules are made via executive decree. But should rules be legislated by Congress, it will become more difficult to influence U.S. policies. The U.S. administration will be more amenable to compromise than Congress because it needs to take into account its broader relationship with Germany and Europe.
Germany, as a country that is very dependent on both China and U.S. has an incentive to nudge U.S. policy away from maximalist policies to the extent that these maximalist policies will sooner or later negatively affect German economic interests by forcing German companies to abide by U.S. rules or risk penalties or even market exclusion. Whether nudging is possible remains to be seen. But without a relatively cohesive EU position on how to regulate technology-related export control and investment policies and without the ability to offer Washington to help make its policies more efficacious in exchange for making them more narrow, Washington will simply forge ahead and lay down the rules, including effectively “secondary” measures that would affect German and European economic interests.
References:
[1] Cooperation should be facilitated by what International Relations scholar call the favourable security externalities of intra-alliance foreign direct investment flows.
[2] See also Markus Jaeger, A More Strategic Approach to Foreign Direct Investment Policy, DGAP Policy Brief, February 7, 2023: https://dgap.org/en/research/publications/more-strategic-approach-foreign-direct-investment-policy
[3] Federal Ministry of Defence, National Security Strategy, October 31, 2022: https://www.bmvg.de/en/national-security-policy; German Federal Foreign Office, Strategy on China, July 13, 2023: https://www.auswaertiges-amt.de/blob/2608580/49d50fecc479304c3da2e2079c55e106/china-strategie-en-data.pdf
[4] Congressional Research Service, U.S. export controls and China, March 24, 2023: https://crsreports.congress.gov/product/pdf/IF/IF11627
[5] Congressional Research Service, The Committee on Foreign Investment in the United States, 2023: https://crsreports.congress.gov/product/pdf/IF/IF10177
[6] White House, https://www.whitehouse.gov/briefing-room/statements-releases/2023/08/09/president-biden-signs-executive-order-on-addressing-united-states-investments-in-certain-national-security-technologies-and-products-in-countries-of-concern/
[7] White House, https://www.whitehouse.gov/briefing-room/presidential-actions/2021/06/03/executive-order-on-addressing-the-threat-from-securities-investments-that-finance-certain-companies-of-the-peoples-republic-of-china/; Office of Foreign Assets Control, Issuance of Chinese Military-Industrial Complex Sanctions Regulations, February 15, 2022: https://ofac.treasury.gov/recent-actions/20220215
[8] U.S. Treasury, Provisions pertaining to U.S. investments in certain national security technologies and products in countries of concern, August 14, 2023: https://home.treasury.gov/system/files/206/Treasury-ANPRM.pdf; White & Case, President Biden orders establishment of new program to restrict outbound investment in certain tech sectors in China, August 16, 2023
[9] Jake Sullivan, the national security advisor, was quoted as saying “We must maintain as large of a lead as possible.”White House, Remarks by National Security Advisor Jake Sullivan at the Special Competitive Studies Project Global Emerging Markets Summit, September 16, 2022: https://www.whitehouse.gov/briefing-room/speeches-remarks/2022/09/16/remarks-by-national-security-advisor-jake-sullivan-at-the-special-competitive-studies-project-global-emerging-technologies-summit/
[10] Markus Jaeger, The Economics of Great Power Competition, DGAP Policy Brief, May 2, 2022: https://dgap.org/en/research/publications/economics-great-power-competition
[11] Congressional Research Service, The International Emergency Economic Powers Act, March 25, 2022: https://crsreports.congress.gov/product/pdf/R/R45618