The Balancing Act -National Security and Foreign Investment

  • The Balancing Act -National Security and Foreign Investment

    The Balancing Act -National Security and Foreign Investment

    One of the significant economic impacts of Covid-19 has been the extent to which national protectionism sentiment has been boosted. In the pre-Covid world of economic expansion, supply chains were run on a “just in time” basis, often at the expense of the maintaining costly strategic reserves of supplies, equipment etc. The advent of the pandemic has highlighted the difficulty which many countries experience in accessing sufficient supplies of medicines, specialist equipment and, lately, vaccines. Such logistical concerns are not simply a matter of production and distribution i.e. a business concern; they are key to surviving and recovering from the pandemic, and consequently viewed as integral to the wider issue of national security.

    There was a time when matters of national security were perceived as quite distinct from business matters in western countries. When former Soviet states were earmarking sectors of their fledgling market economies as key to national security, and designating some industries as giving the government a “golden share” option, western countries and businesses were critical of this centralised approach. Of course, that was at a time when established western companies were keen to invest in the newly-emerging markets of Eastern Europe and elsewhere, and sought the freedom of access considered necessary for investment. The passage of time, however, has tempered that outlook as emergent and emerged economies have in turn sought to become investors beyond their own shores. The security and economic implications for western countries, pre- and post-Covid, are considerable.

    The impact is not limited to the west, however. Companies aiming to invest in China must reckon with the newly introduced (January 2021) measures for the security review of foreign investment. While the measures are new, the principle that foreign investments must be scrutinised for national security reasons (undefined in the new measures) is not. However, Beijing has seen fit to update its scrutiny regime to include not just direct investment but indirect investment. Key services (again, undefined) in a wide range of sectors will come under the purview of government scrutiny, and potential investors will need well-tuned political antenna, as will existing investors aiming to sell their investments to non-Chinese buyers.

    The USA and a number of EU member states have all been engaged in reviewing their screening programmes for foreign direct investment (FDI), a review given greater immediacy because of the pandemic, but also because of the influence of major global investors from China and Russia, among others. Leading European economies such as Germany, France, Italy and a number of others have all conducted reviews of how they reconcile national security concerns with the desire for open economies, and avoiding a protectionist retrenchment.

    Of particular interest is the case of the post-Brexit United Kingdom. With London arguably the world’s principal money market[1], the UK has long been the destination of choice for many wealthy investors, not all of whom are necessarily regarded as desirable partners – see our earlier article “A new understanding of British reserve”. Brexit notwithstanding, there are many reasons why London should be an attractive investment location; legal transparency and the rule of law as effected by an independent judiciary are just some of the attractions. As with its European neighbours, London is reviewing its FDI screening programme with a view to introducing legislation to obviate risks to national security.

    The UK’s Department for Business, Enterprise and Skills (BEIS) has the lead on producing draft legislation for Parliament’s consideration. At the time of writing, the draft bill needs to clear several more procedural hurdles before becoming law. Already, however, the draft legislation contains flaws that have the potential to render it less than optimal. For example, the draft lacks a clear definition of what, exactly, constitutes “national security”.

    To be fair to legislators, this is not an easy concept to define; also, the UK is far from being the only country which does not apply a definition. Traditionally, national security has been predicated upon so-called “hard power” considerations such as the defence of physical borders. Over time, however, economic considerations have become more prominent in security thinking – echoing “golden shares” – but legislation has not kept pace with technological advances. While it can be argued that a strict definition of national security is not necessary, or lack of it a good thing in so far as it avoids regimented thinking, the debate over the need for a definition itself exposes a lack of clarity and a level of disagreement at the heart of government.

    The draft legislation also lists a wide range of sectors as coming under the purview of national security. This runs a couple of risks, the first of which is overkill, whereby investments which are at best tangential, marginal or even unrelated to national security – but within listed sectors – are reported erroneously. The second risk is that of deterring investment altogether, thereby defeating the object of the review exercise. There is also the issue of subsequent review, whereby Government reserves the right to review transactions for up to five years beyond the date of completion. This has a rather arbitrary ring to it, and could well lead to investors reporting by default to ensure that transactions do not fall foul of subsequent government interpretation of the need to report. Such over-reporting is likely to lead to false positives in terms of security concerns, a phenomenon familiar to Chief Compliance Officers and their staffs everywhere.

    Finally, there is the question of governmental capacity to address the tensions inherent in balancing national security concerns with economic needs in the post-pandemic, post-Brexit world. The economic damage wreaked by Covid-19 has hit all governments hard. The UK economy must also wrestle with the added “teething problems” of Brexit. The country is therefore feeling its way carefully in the world of trade and investment, and there is doubtless a temptation to demonstrate the value of Brexit in terms of inward investment, creating a tension between economic and security considerations.

    In the wider picture, investors will need to pay closer attention to the politically driven national security concerns of host countries, especially as the hosts will reserve the right of review for considerable periods of time ex post review. Government affairs departments – for those, generally multinational, enterprises which have them – will find themselves busier than usual once legislation has made it onto the statute books. Political risk factors will continue, therefore, to be a central and growing consideration for investors large and small.

    [1] We note, however, that at the time of writing, it has been overtaken by Amsterdam in terms of European share trading, a consequence of the UK’s recent exit from the EU.

    Mark McGuigan is TSG’s geopolitical risk advisor specializing in the CEE region. He is a former financial sector intelligence consultant and an ex-RAF officer. He writes here in a personal capacity. TSG is a research (including due diligence) specialist, also offering Ethics Compliance and Advisory services to its clients. TSG offers expertise in Eastern Europe, as well as East Asia.