China’s new state-backed venture capital fund to boost innovation

China’s new state-backed venture capital fund to boost innovation

China recently announced the establishment of a new $30bn state-backed venture capital fund. In a bid by Beijing to bolster innovation, the fund demonstrates a belief in China’s entrepreneurship, but will it live up to the buzz?

China recently announced a $30bn venture capital fund in hopes of fostering reform of state-owned enterprises (SOEs) and spurring nation-wide innovation. Supported by the State Council with China Reform Holdings Corp as the main backer, the establishment of this fund is an attempt by the government to look for more market-friendly ways to consolidate state assets and make it easier to steer funds towards specific projects.

Despite worries concerning inefficiencies in asset allocation and governance, the gamble made by the government in establishing this fund could prove economically beneficial in the long run. If Beijing is successful in upgrading its state-owned firms through reasonably effective investment in promoting high-tech industries, it could aid in rebalancing the Chinese economy away from a reliance on investment towards consumption-led growth. However, given the political realities that constrain policy and the current saturation of the venture capital market in China, the success of this fund may not only take years, but also requires thoughtful oversight.

Venture fund by name, government tool by nature

The government-approved fund, which was given the green light on August 8th, will be established in the Southern city of Shenzhen, known as the region’s tech hub. Initially, the fund will launch with a sum of $15bn, planned to increase to $30bn. The key aim of the fund is to upgrade China’s technological capabilities and boost industrial innovation. Central to the initiative is a reform of SOEs, seen as vital in revitalising China’s economy.

There are more than 150,000 state-owned firms in China, over 100 of which are under control of the central government. Despite the important roles played by SOEs, their profits have dwindled in line with the Chinese economy in recent years. Effective reform of SOEs in China could be the biggest uncertainty, but also the greatest potential gain in effectively boosting innovation and rebalancing the world’s second largest economy. By establishing a $30bn venture capital fund, Beijing hopes it will enable the rise of a new economy, substantial enough to counterbalance the fall in the old sectors. Accordingly, although referred to as ‘venture capital’ in name, the fund exists first and foremost to serve the needs of the government.

While a number of changes to SOEs have been undertaken, many of these have consisted of encouraging mergers and acquisitions with the aim of consolidation – often by selling off non-core assets. Private funding has proved unpopular, predominantly due to private investors being much less likely to control the decision-making process in SOEs, which has meant that major decisions in these institutions have been hostile to change.

Increased effort to weed out the zombies

The launch of this fund paves the way for China’s industrial firms to rise up the value chain via technical innovation and tougher efficiency standards. The aim is to improve the competitiveness of major conglomerates on a global scale. By establishing this fund, the government has indicated it will be more selective in how it distributes funds, and stop funding for firms that are unable or unwilling to upgrade.

In 2015 alone, nearly 300 funds totalling $230bn were established. This was part of Chinese Premier Li Keqiang’s drive to promote technology and innovation. The newly announced fund is yet another VC fund backed by the Chinese state in colour, but of a slightly different shade. Unlike existing funds targeting consumer-focused startups, this one will invest in startup ventures that could increase the efficiency of state-owned industrial companies, which have now also become to be known as ‘zombies’.

The double whammy of inefficient  zombie firms and excess capacity have long called for a solution. The government’s emphasis on private investment reflects a worry that it has been unable to cultivate a favourable business environment, despite attempts to break the cycle of credit for unproductive – but politically well-connected – SOEs with supply-side reforms. This fund is seen as killing two birds with one stone by offering both demand-side measures and supply-side measures, more commonly known as macro-stimulus and structural reform respectively.

Overcoming structural flaws in zombie SOEs

Traditionally for SOEs in China, government officials effectively function as representatives of ownership, meaning the motivation to succeed for those in charge is less than it is in capitalist economies. As Zhang Weiying of Peking University points out, “in China’s SOEs there is no ownership authority or constraint, and therefore no pressure to innovate. In a market economy, members of a business must be innovative and strive to make the business a success, because they are held accountable by the business owner.” Creating a fund which follows a more market-oriented style of management acts to counter the lack of incentive to innovate.

Furthermore, establishing this fund also seeks to solve another structural flaw driving China’s instability: the ‘soft budget constraint’. This is  an investment situation, where SOE profits are privatised to SOE personnel, while losses are merged with the state budget. The result of this is reckless investment by SOEs and a complacent willingness by state-owned banks to supply funds for the investments.

With the new fund, Beijing hopes not only to have greater authority over the performance and direction of credit, but it also intends to add extra layers of checks to the efficient allocation of funding. The end goal of the fund is to bolster innovation and entrepreneurship, meaning that overcoming the existing structural flaws with regard to SOEs is imperative.

The fund as a catalyst for innovation

According to McKinsey, China must generate two to three percentage points of annual GDP growth through innovation during the next decade. The government hopes the new fund will provide the necessary capital to key projects, which will in turn act as a stimulus for increased economic development.

China may have become a strong innovator in some areas such as consumer electronics, yet in others such as pharmaceuticals or automobiles, the country still falls short of being truly globally competitive. In March 2016, the State Council ran a piece in which it stated that entrepreneurship and innovation “not only refers to being innovative in fields of technology, commerce, and culture, its essence lies in the innovation of ideas and systems, which can inject more creative vigor into the public.” China realises it needs to develop the ‘twin engines’ of mass entrepreneurship and innovation as well as the old engine of improved public goods and services, if it wants to meet or indeed surpass projected growth rates.

The announcement of this fund is thus a stimulus aimed at innovation and entrepreneurship; an alternative to simply releasing a lot of liquidity into the system, which would likely end up in property and financial companies.

The likelihood of success depends on effective governance

Economies with high savings rates, such as China, also have high investment, and the absence of capital market reform in China, worsened by the equity bubble bursting in 2015, is testament to the disproportionate role played by bank credit in funding investment in China. China’s inflated SOEs present a prime target for reform.

A more cynical response to this fund is that it might be yet another dumping ground for underperforming SOEs as well as a way for corrupt officials to exit ill-conceived business ventures. Arguably, the most sensible approach for China at this moment would be to incubate and develop growing businesses, filling a space occupied by VC companies in the economy. This would be a useful way to deploy reserves without causing inflation, especially since China, like most other places, is in a low-yield environment, which entails somewhat of an asset famine. As a result, sooner or later investors will want different assets to diversify.

However, this pessimistic view fails to understand that the reason there has been no genuine attempt to set benchmarks for improving the efficiency of SOEs is that the problem is political as opposed to economic. The key to the success of this new fund comes down to a matter of effective governance.

The fund may enable the Chinese government to effectively reform zombie SOEs by allowing price signals from competitive markets to guide resource allocation, strengthening national innovation, ensconcing social programs that ensure inclusive economic growth and accelerating upward social mobility. Achieving these outcomes will not only steer China clear of the middle income trap, but amplify innovation and entrepreneurship on an unprecedented scale.

About Author

James Tunningley

James Tunningley is a GRI Associate Analyst. He is the Director of the Young China Watchers in London having previously held positions at the Royal United Services Institute for Defence and Security Studies and the China-Britain Business Council. He is on the Young Leaders Program at the Center for Strategic and International Studies Pacific Forum, a Fellow at the Royal Asiatic Society and a Junior Member of the Royal Society for Asian Affairs. He is a graduate of the University of Oxford.