How countries can regulate investment screening

To attract investment, certain regulations can help countries understand the size of the garden (where investors can play) and the height of fence (to keep out malign actors).

Expert comment
Published 13 April 2022 Updated 20 April 2022 3 minute READ

Vasuki Shastry

Former Associate Fellow, Asia-Pacific Programme

Investment screening has become an important component of the policy toolbox of nations, with the objective of blocking inward investment by foreign actors over concerns of national security and retaining competitiveness.

Three recent developments have placed investment screening at the heart of national economic policy:

  • The rise of China, accompanied by massive outward investments by state-owned and private firms in sensitive and non-sensitive sectors.
  • The COVID-19 pandemic, which exposed deep weaknesses in supply chain reliability and the resilience of many nations, notably in the G7.
  • The Russian invasion of Ukraine, which triggered unprecedented American and European sanctions against Russia, is unfolding and is bound to have a long-term impact on the rules for inbound investment.

As countries shore up their defences, through tighter investment screening and foreign direct investment (FDI) criteria, policymakers should be alive to the risk that the new processes create unintended consequences.

The objective should be in weeding out malign actors through a rigorous and transparent process, while keeping the door wide open to investment in other sectors.

This would include creating a chilling effect in deterring overall FDI, which has the potential to exacerbate macroeconomic imbalances (since FDI inflows support the current account) and damage the reputation of the country as an investment destination.

The objective should be in weeding out malign actors through a rigorous and transparent process, while keeping the door wide open to investment in other sectors in the country. Global cooperation through information sharing and mutual recognition of investment rules, with an initial focus on the G7, will send a positive message to genuine investors.

Examples from Europe and Japan

A good starting point is  examining the raft of new investment screening and FDI legislation introduced by developed nations in response to the pandemic and efforts to block investments in sensitive sectors.

New legislation has been introduced in the UK via the National Security and Investment Act which gives the government considerable powers to screen investments on national security grounds.

Japan has made several amendments to its existing Foreign Exchange and Foreign Trade Act which are aimed at strengthening investment restrictions in certain sensitive sectors.

During the pandemic, the European Union (EU) introduced a framework for screening FDI which provides a notification platform for all member states and an EU-wide platform for exchange of information.

The objective is to ensure that there is greater coordination across the EU and to disincentivize non-EU investors from conducting regulatory arbitrage by directing investments toward states with weak legislation and investment screening rules.

Course correction in the US

Even in the US, which has had a well-established Committee on Foreign Investment in the United States (CFIUS) process for several decades and is regarded as best practice amongst developed nations, lawmakers have tweaked the rules to provide greater clarity in screening foreign investments in ‘critical technologies’.

In the eyes of critics, the 2018 updating of the FIRR Act was put to egregious use by President Trump, notably in the TikTok case over data security concerns. Critics have pointed out that the FIRR allowed the executive branch ‘to weaponize national security interests for political gain’. 

The Biden administration has wisely carried out a course correction. The FIRR initially had an outbound investment screening component which did not make it into the final legislation, but efforts are underway in Congress to introduce an outbound CFIUS process. This would target investments that seek to shift ‘investment, ownership, or business activities that relate to national critical capabilities into entities or countries of concern’.

Beijing realigns with the US and Europe

The new rules across the G7 have not gone unnoticed in China, which regards its companies to be the primary target of tighter screening. In response, Beijing has also moved to identify and limit foreign investments in several sensitive sectors of its own with the specific objective of realigning its rules with the US and Europe.

Other developing countries are also likely to join the fray with the OECD alone estimating that the share of FDI subject to screening has increased to 60 per cent within the grouping. This raises several strategic economic policy and national security issues for countries which are still eager to retain the pace of FDI inflows with the overriding concern of ensuring that the investment adheres to national rules.

Lessons from the last few years

Four lessons from the last few years are instructive in this regard:

  • First, the costs of inadequate protection via screening legislation are usually very high for countries. Besides the loss of competitiveness, retroactive screening legislation introduced by governments often comes too late to resolve the underlying national security concerns.
  • The objectives of national security should be to ensure that a country’s supply chain is generally in friendly hands, reducing vulnerabilities and over-dependence as demonstrated by the pandemic. This may not entirely be possible given the diversity of countries in a supply chain and better risk mitigation measures may help.
  • Investment screening requires closer coordination and dialogue between national policymakers and the private sector on the overall framework for limiting national security risks as well as individual cases, which has perhaps not been a regular feature in the past.
  • FDI screening should be regarded as a normal bureaucratic discipline and the new legislation in G7 nations should attempt to address deficiencies, including in transparency and accountability.

However, there is a greater issue of a lack of coordination, within and across national boundaries, which could hurt implementation of well-meaning legislation.

Why lack of coordination is a problem

Japan is an interesting example where the government efforts to address national coordination is facing some turbulence, both from within the bureaucracy as well as the business community.

Although Japan has designated twelve industrial domains – including arms, space, cyber, water, electricity, sewage, the rail network, and oil refining – which are on the negative list for FDI, wider economic security considerations prompted the authorities to further tighten screening in the updated legislation.

This raises broader concerns, well beyond Japan, of whether investment screening rules could be subject to regulatory capture as powerful government entities seek to protect national champions and block FDI in genuine sectors.

Such concerns could be addressed through greater cross-border cooperation and harmonization of screening rules to ensure that in non-sensitive sectors, countries are operating on a level playing field and protectionist impulses are curbed.

Mutual recognition of regulatory regimes will allow countries to fast-track foreign investments in their respective jurisdictions.

One way of achieving this objective is through mutual recognition of FDI rules, ideally amongst a grouping of nations at similar levels of development (the G7, for example), shared concerns over national security, and comparable depth in national legislation.

Mutual recognition cont.

Mutual recognition of regulatory regimes will allow countries to fast-track foreign investments in their respective jurisdictions. This may not be a panacea for addressing all the weaknesses in cross-border investment screening.

It is perhaps equally important for like-minded countries to agree on a set of common principles which they all commit to follow, as the OECD is attempting to do, to prevent abuse and maximize effectiveness in screening  countries that pose a risk.

These approaches will help in establishing a common understanding of the size of the garden (where foreign investors can play) and the height of fence (to keep out malign actors) when it comes to attracting desirable foreign investors and in deterring undesirable ones.