Venture capital (“VC”) is widely recognized as a powerful engine that can drive a nation’s innovation, job creation, knowledge economy, and macroeconomic growth. As such, governments from various jurisdictions around the world have tried to promote the development of VC markets. Generally, government programs have not been especially successful.
China offers a fascinating case study of how a VC market can be engineered – its VC market is one of the fastest developing and largest engineered markets in the world. Before 1985, VC did not exist in China. But after three decades of development, China now receives the second largest annual VC investment in the world. In 2016, 636 new VC funds were set up in China, collectively raising more than USD 52.07 billion of fresh capital for investment. This represented a 79.4% increase over the previous year.
In contrast to the U.S., China’s VC market did not emerge as a result of market forces alone, but was instead consciously and strategically designed by the state from the outset. China’s fascinating experience challenges the orthodox view that top-down governmental efforts to promote VC are likely to be unsuccessful. Moreover, China succeeded in building a VC market despite what commentators have considered weak investor protection and a lack of judicial independence, all of which have raised questions regarding the effectiveness of private ordering in China. The pivotal question is: “How has China managed to create the second largest VC market in the world despite its immature legal infrastructure?”
My recent paper, “Engineering A Venture Capital Market: Lessons from China”, analyzes Professor Ronald Gilson’s theory of “simultaneity” in engineering a VC market in the context of China. Based on both quantitative and qualitative data, the article explores the elements of China’s experience in engineering a VC market, as well as concerns about its continued growth. It concludes that the rise of VC in China is attributable to (1) increasing capital supply through various governmental programs, easing regulatory barriers towards institutional and foreign investors, providing tax incentives and improving the exit environment; (2) enhancing the availability of financial intermediaries by introducing the limited partnership, which creates an efficient relationship between venture capitalists and investors; and (3) encouraging entrepreneurship by improving the regulatory environment for small businesses. Through these measures, China has facilitated the simultaneous availability of capital with the appetite for high-risk, long-term investments and the emergence of a class of entrepreneurs with the skills and incentives to put that capital to work. A key factor of the rapid development of the Chinese market has been its increased reliance on market forces in allocating capital.
On the other hand, the Chinese government’s role in allocating capital is not without flaws. There are institutional obstacles, including the flawed cadre appointment system and the flawed incentive mechanisms of government officials, that prevent local governments from achieving the delicate balance of allowing local government funding to operate based on market forces while concurrently pursuing the governments’ policy goals. This residual degree of bureaucratic allocation prevents the Chinese regime from being fully efficient. China serves as an (imperfect) model for other governments seeking to engineer a VC market where enfettered market forces have failed to do so.
The lesson to be learned from the Chinese experience is that the optimal role of a government in engineering a VC market should be to provide the necessary enablers, while playing only a limited role in the capital allocation process and leaving specific capital allocation decisions with the right incentives. This is a lesson that could be valuable to other countries, such as Japan and Germany, that have attempted to promote the development of a VC market without significant success so far.
Lin Lin is an Assistant Professor at the Faculty of Law of the National University of Singapore.