Cross-border investment barriers: issues for institutional investors

Protectionist trade policies are back in vogue, fuelled by the rise of China’s economy and, more recently, by the escalation of geopolitical tensions. Tariffs, import quotas and other hurdles are on the rise, as the major trade blocks of the US, China and the EU seek to ‘de-risk’ the patterns of global supply chains. 

Much less noted is another ongoing important trend: the expansion of barriers to global capital movements. Governments worldwide are ‘protecting’ more and more sectors from foreign investors to defend ‘national security’ or similar national interests. Foreign direct investment (FDI) has fallen in the developed world from the peak of around $2tn in the years 2015-16 to less than $1trn. Emerging markets have held up better, thanks primarily to flows within Asia, according to UNCTAD and the OECD. 

Such political action was originally spurred by the hyperactivity of (often state-controlled and state-promoted) Chinese companies in the 2000s. However, new foreign investment laws tend to have a broader remit. Unfavourable policy measures for inward FDI include: 

• barriers to certain types of investments by overseas investors;
• sectoral exclusions for FDI;
• ownership constraints, eg, shareholding limits, land acquisition;
• ‘local content’ requirements, conditions on local labour employment or technology sharing;
• subsidies and taxation; 
• tighter FDI notification and approval procedures. 

This evolution is exemplified by the remarkable expansion of FDI screening mechanisms to safeguard national sovereignty. The list of countries with such legislation has grown from less than five in the early 2000s to 41 in 2023, with accelerating pace over the last five years (see figure). 

As a new development, FDI restrictions also affect outward FDI for economic transactions related to sensitive sectors for national security. 

“The concept of ‘national security’ has undergone a transformation over the years, increasingly integrating ‘economic security’ considerations”

Georg Inderst 

The concept of national security has undergone a transformation over the years, increasingly integrating ‘economic security’ considerations. The scope of FDI rules has generally been expanded from defence and traditional infrastructure to include ‘softer’ sectors such as critical knowledge and strategic technologies, data or research and development (R&D). Some examples in OECD markets include:

Australia: one of the first countries to apply more stringent FDI rules. Over the years, the range of ‘critical infrastructure assets’ was substantially extended beyond transport, energy, telecommunication and hospitals to areas such as data processing, cybersecurity and supply chains.

United States: relevant jurisdiction has been widened to investments in US businesses involved with critical technologies and infrastructure, sensitive personal data, and certain real estate transactions. In 2022, the scrutiny was tightened further in the areas of cyber security, quantum computing and biotechnology.

United Kingdom: the UK introduced a more extensive National Security and Investment regime in 2022. Certain acquisitions of entities active in 17 ‘sensitive’ sectors require mandatory FDI notification and clearance. These widely defined sectors cover defence, critical transport, energy and materials, data and communications, advanced technologies and biology, suppliers to government and emergency services. 

European Union: the EU framework, in place since 2020, does not create an EU-level FDI regulation but sets out minimum requirements for member states’ FDI screening mechanisms and communication.

It includes critical physical and virtual infrastructure, technologies, supply of important inputs (eg, raw materials, food security), sensitive information, freedom and pluralism of the media. Germany, France, Italy, Spain, Poland, the Netherlands, Sweden and most other EU countries have recently introduced or tightened FDI regulation. 

Taking Germany as an example:  the list of security-relevant areas of FDI with notification requirements was enlarged from 11 to 27 in 2021. In addition to defence, there are seven more critical sectors with stricter filing rules (energy, water, finance, healthcare, transport, telecommunications, cloud computing services, telematics or media industry). Lighter regulation applies to areas such as essential pharmaceuticals, artificial intelligence, robotics, semiconductors, aerospace cybersecurity, quantum-based technologies and nanotechnology.

Impact on institutional investors

The extension of cross-border investment regulations is potentially relevant also to asset owners and managers. First, there are the macro-economic effects of protectionism on capital flows. This is detrimental to an open global investment environment, harming productivity and growth.

Second, the new ‘soft’ sectors covered by new FDI rules (such as digital assets, high tech and communication) are becoming very substantial for institutional investors. 

Third, countries differ in their approach to additional sectors deemed ‘critical’, such as land and real estate, public health, water and sewage, agriculture and food supplies, mining, shipping, financial services or media.

Fourth, uncertainty is created by the changing interpretations of ‘strategic’ assets. The exact meaning remains subject to interpretation by the authorities. There is usually little transparency about that. It is indeed difficult to generalise when a product is, for example, a ‘dual-use item’ (for civil and military use). 

Fifth, the actual application of FDI laws varies widely, ranging from routine box-ticking to deep investigation and complicated negotiation about special conditions for transactions. 

Government interventions

The actual number of significant government interventions in deals is still relatively small – but the trend is upward. Some high-profile cases of cross-border investments or takeovers have already received public attention: ports, grids or pipelines in Australia; nuclear power and utilities in the UK; airports, energy, communication and technology companies in the EU, the US and other places. A recent case was Budapest airport, which has been returned to majority state ownership from investors such as GIC and CDPQ.

How to adjust the asset allocation process?

Asset owners’ practical experience with the new foreign investment regimes is still limited, but it is worth their while to get prepared:

Investment vehicles: the involvement with national security laws can be a) direct; b) via delegated fund managers; or c) through investee companies, whether listed or private equity.

“Officials often like to showcase domestic investment opportunities to overseas institutions at the same time as they raise cross-border investment hurdles”

Georg Inderst 

Type of investor: state-linked institutions such as sovereign wealth funds are naturally more affected than private-sector pension funds or insurance companies. Passive, non-controlling organisations with smaller stakes are likely to face a lower level of scrutiny in the process.

Co-investment: partners in a joint venture or syndicate may be affected by new FDI rules for their domicile.

Investment opportunities and diversification: investment barriers reduce the set of international allocation opportunities. Sectoral exclusions do not help the diversification of portfolios that are often concentrated or home biased.

Delays and costs: FDI approval can cause delays and disruption in the transaction process. FDI due diligence, reporting and negotiation, possibly with the use of external advisers, adds to the costs. 

Capacity, lobbying: long-term investors need to build appropriate expertise for active management; some have started to hire (geo-)political analysts. Outsourcing to experienced, well-resourced managers may be easier. Larger organisations may choose to dedicate more time to ‘engage’ with the regulators. 

Loans and bonds: debt managers, too, need to stay on top of developments in the underlying businesses, even if money lending as such is typically not within mandatory notification. 

Unfortunately, government policies are often inconsistent. Officials like to showcase domestic investment opportunities to overseas institutions at the same time as they raise cross-border investment hurdles. FDI restrictions can be popular with domestic investors as there is less competition for assets from foreigners. However, such advantages may only be short-lived. 

Investors may react differently to more complex regulation in a fast-changing (geo-) political climate. Some may opt to diversify even more actively and globally; others may become more conservative by looking at their home market for less liquid assets or shorten their time horizons. Moving away from liberal investment regimes is a trend that is likely to stay for the medium term. 

Dr Georg Inderst is an independent adviser to pension funds, institutional investors and international organisations