By Jing Yang and Dawn Lim

President Trump's recent executive order prohibiting Americans from investing in companies tied to China's military complex has set up a fight in the highest ranks of government over how broad the list should be.

Since November, the White House barred U.S. investors from buying into 35 Chinese companies the Pentagon has classified as aiding China's defense, intelligence and security apparatus. It sparked selloffs of Chinese stocks and bonds, forced index firms to drop companies from marquee benchmarks, and pushed Wall Street to reassess risks from investing in China.

Now, the U.S. government is at odds over whether the blacklist should include subsidiaries of the companies. Another battlefront is over whether affiliates should be included. The question affects how much teeth the ban will have.

State Department and some Defense Department officials want the executive order to have the widest reach, said people familiar with the matter. They are arguing that excluding subsidiaries or affiliates creates a loophole and ignores the reality of capital markets, some of the people said. Most Chinese companies, especially state-owned firms, tend to list their subsidiaries and affiliates on the stock market, and may issue bonds through these or other units.

Treasury wants the blacklist to only include the companies specifically flagged by the Pentagon, and not affiliates or subsidiaries, the people familiar with the matter said. That is a view generally embraced by many on Wall Street given the fear that a broad list could spook markets and prompt large amounts of forced selling to scrub portfolios of problematic stocks.

"As directed in the law, we will build out the list to include Chinese entities owned by, controlled by, or affiliated with the Chinese military, government, or defense industry that operate directly or indirectly in the United States (including through trade and investment flows)," John Supple, a Defense Department spokesman, said in an email.

A State Department spokesperson said the department doesn't comment on interagency deliberations. Treasury is executing the order and coordinating with other agencies, a senior official at the department said.

A draft version of Treasury's guidelines on how the rule should be implemented doesn't include affiliates and subsidiaries. The agency tried to publish the list over the past week-and-a-half but faced pushback from State Department officials, said some of the people familiar with the matter.

The battle pits the office of Treasury Secretary Steven Mnuchin against that of Secretary of State Mike Pompeo, who has long said the funding of Chinese state-linked companies by U.S. investors undermines national security. Government officials predict that the stalemate will only be broken when President Trump weighs in, one of the people said.

Treasury is tasked with providing guidelines over how the rule will be implemented, after consultation with the secretaries of state, defense and other agencies, according to the executive order.

"Throughout the Trump administration, the hard-liners and free traders have fiercely fought every inch of this trade war," said Ed Mills, Washington policy analyst at Raymond James. "Mnuchin is trying to see if he can win the last battle."

The executive order made in November bars trades in "securities that are derivative of, or are designed to provide investment exposure to such securities, of any Communist Chinese military company." But the order didn't provide specifics around how "derivative" should be defined and whether subsidiaries and affiliates would be included.

The list includes popular holdings such as state-owned railcar maker CRRC Corp., China's top chip maker Semiconductor Manufacturing International Corp., and Hangzhou Hikvision Digital Technology Co., which sells surveillance gear to track Chinese citizens and technology that is installed world-wide. Government officials have seen these companies as vehicles through which Beijing gets access to technologies and military capabilities.

"This has become a stark debate between the security community and Treasury and who's going to be given the mandate to interpret and execute the president's intentions," said Roger Robinson, president and chief executive of RWR Advisory Group and former chairman of the U.S.-China Economic and Security Review Commission.

So far, major index providers have taken a narrow interpretation of the executive order.

MSCI Inc. this week announced its decision to drop stocks in seven Chinese companies from marquee indexes and specifically said it was only deleting companies named in the order and "not any subsidiaries or affiliated companies."

The move amounts to less than 1% of the MSCI China Index's market cap, and leaves untouched popular holdings such as China Mobile Ltd. and oil major Cnooc Ltd. -- both subsidiaries of companies identified by the executive order -- which together make up for 1.7% of the index, according to a research report by Gavekal Dragonomics.

Similarly, FTSE Russell, another major stock index provider, said it would remove eight Chinese companies and make amendments according to "an official list of sanctioned securities" to be published by the Treasury Department's Office of Foreign Assets Control.

The State Department published its own fact sheet on index funds' exposure to the companies at the beginning of December. It said at least 24 of the 35 companies classified as Communist Chinese military companies had affiliates that were part of a major index.

Meanwhile, asset managers are reaching out to the Biden transition team to try to understand how a new administration would interpret the executive order. U.S. investors are barred from the purchase or investment in stocks, funds or other financial products that include the firms, starting Jan. 11. The order gives investors until November 2021 to get rid of their exposure to the Chinese securities.

--Gordon Lubold and Kate Davidson contributed to this article.

Write to Jing Yang at Jing.Yang@wsj.com and Dawn Lim at dawn.lim@wsj.com

(END) Dow Jones Newswires

12-17-20 2157ET