How Government Guidance Funds Stimulate Open Capital in China
Government Guidance Funds and the Role of the State in High-Tech Industries
Hello, my readers! I had a busy national holiday, so I was unable to update during the week. For today’s episode, I will bring an article about government guidance funds. When discussing this subject, thanks to the excellent reporting by Bloomberg and The Economist, the "Hefei Model" often comes to mind. This is usually described as a local government that plays a significant role in identifying and supporting key high-tech industries and companies, going in as patient capital and polling out after their market prospects become clearer, which could attract interest from non-government investors.
So, for the article, I picked one that goes deeper into local government motivations for setting up such funds and their role in high-tech industries. Titled: "Leveraging Capital with the Visibel Hands of Nation— Government Guidance Funds and National Roles in High-Tech Industries," It was first published by WenhuaZongheng(文化纵横), they really good at picking up high-quality Chinese articles.
This article is by Professor Huang Dongya and Zhang Chenqian. Professor Huang is an associate professor at the School of Government at Sun Yat-sen University. Professor Huang has significantly contributed to our understanding of the intricate relationship between the Chinese government and enterprises. I translated one of the podcasts she joined in June.
Link:
Professor Huang explained that budgetary motivations drive local governments' decisions to establish guidance funds. The fund contains multiple goals, and there are tensions among objectives such as market returns, fiscal fund safety, preservation and appreciation of state-owned assets, and local development; these goals need to be coordinated. It also brings new challenges for local officials to identify promising high-tech companies.
Full text:
Industrial development is not only driven by industrial revolutions and technological innovations, nor does it solely rely on marketization and entrepreneurial spirit. At its core, it is closely related to capital factors. Especially for high-tech industries, obtaining capital investment is crucial for promoting their development. The emphasis on the importance of capital for innovation can be traced back to Schumpeter's theory of "creative destruction" and has now evolved into the view that "more capital leads to more innovation."
The development of high-tech industries not only needs to solve the challenges of technological accumulation and scientific innovation, but also faces the weakness of infant industry market competition and the squeeze of market opportunities by first-mover countries. It requires "patient capital" that does not aim for short-term profit returns but can tolerate longer-term and uncertain development. During the Nixon era, the wave of financial liberalization in the United States and the business model of platform companies building infrastructure to achieve market dominance made patient capital possible. Apple's success is also partly attributed to the wave of patient capital investment in new technologies such as the Internet, GPS, touchscreens, and communications. From this perspective, this patient capital is the core force driving the rise of the platform economy.
However, not all high-tech industries are so fortunate, especially for late-comer enterprises in catching-up countries. Research and development challenges, infant industries, and the squeeze of market opportunities all increase the uncertainty of capital returns, making patient capital even scarcer. In the development process of high-tech industries, the role of the state is not only to open up and protect markets, provide industrial policy support, and invest in research and development, but many countries have played a more active role: in providing patient capital, government actions include funding national research projects, military projects, and public procurement for technology development, public funds invested in public laboratories to promote key technology research and development, as well as tax incentives and trading strategies provided by the government. In addition, direct equity investment by the government in the early stages of industrial development is also an important form.
In 1958, the U.S. Small Business Administration (SBA) launched the Small Business Investment Company (SBIC) program, which attracted private capital participation through measures such as loan preferences, debt guarantees, and equity guarantees and supported famous companies such as Apple, Intel, and FedEx. In the UK, the UK Innovation Investment Fund (UKIIF) mobilized private capital to participate in venture capital fundraising; the Scottish Seed Fund addressed the financing difficulties of small and medium-sized enterprises at the local level. In 1993, the Israeli government established the equity investment fund YOZMA, setting up venture capital sub-funds to cultivate private sector venture capital capabilities to target investments in start-up science and technology enterprises. The Australian government established the Innovation Investment Fund (IIF) in 1997 to support start-ups in fields such as biomedicine and the Internet.
In China, the form of providing patient capital for high-tech industries through state equity investment has also gradually developed, becoming an increasingly important means of national industrial policy.
I. Multiple Drivers of Government-Guided Funds
Over the past few decades, the state's patient capital has been quietly growing in the form of "guided funds." These funds first appeared in the venture capital field and gradually developed towards innovation investment and industrial investment. They are not only driven by national policy orientations on entrepreneurship and innovation but also propelled by the new budget law and state-owned enterprise reforms.
Let's first look at the promotion of government-guided fund policies. Government-guided funds initially developed in the venture capital field. In 1986, to complement the implementation of the "Torch Program," the Ministry of Finance and the State Science and Technology Commission initiated the establishment of China New Technology Venture Investment Corporation, the first venture capital company in mainland China. Subsequently, local governments also began to explore the establishment of various venture capital companies.
In 2005, the "Interim Measures for the Management of Venture Capital Enterprises" was introduced, allowing national and local governments to set up venture capital government-guided funds. In 2007, the first national-level venture capital guided fund, the "Venture Capital Guided Fund for Technology-based SMEs," was officially established with 100 million yuan allocated by the central government. In 2008, the state stipulated the nature, fundraising sources, operational methods, and principles of venture capital guided funds, marking the entry of guided funds into a formal operational stage. Around 2010, the state further resolved issues such as the transfer of state-owned shares after the listing of venture capital-backed companies and the distribution of GP management fees.
Although government-guided funds were initially aimed at the venture capital field, they made preferential provisions for high-tech industries. They required that venture capital enterprises supported by guided funds should stipulate in their company charters or limited partnership agreements that they should invest a certain proportion of funds in early-stage enterprises or start-ups in high-tech and other industrial fields that need government support and encouragement. In 2007, the Ministry of Science and Technology affirmed the function of "guided funds supporting the entrepreneurship and technological innovation of start-up science and technology SMEs."
Besides venture capital, government-guided funds have gradually developed in the forms of innovation funds and industrial investment funds, with an increasing emphasis on supporting high-tech industries. In 1999, the Ministry of Science and Technology and the Ministry of Finance first proposed that "innovation funds are a type of guided fund." In 2016, the National Development and Reform Commission further expanded government-guided funds from venture capital to broader industrial investment areas. The NDRC defined "government-funded industrial investment funds" as "equity investment funds and venture capital funds funded by the government, mainly investing in non-publicly traded enterprise equity."
Secondly, let's look at the boost from the new Budget Law. The rise of government-guided funds was not entirely driven by national entrepreneurship and innovation goals and policies. Although guided fund policies began to appear in 2005, it wasn't until 2015 that government-guided funds developed rapidly. The introduction of the new Budget Law in 2014 was an important driving force.
The Budget Law introduced in 2014 defined the concept of surplus and carry-over funds. In the same year, relevant implementation documents were issued, and the state began to establish a regular clearing mechanism for carry-over and surplus funds, increasing the coordinated use of carry-over funds. In this context, to ensure government money is spent and not reclaimed, the government began using "equity investment" to revitalize existing fiscal funds, as equity investment is a long-term fund that can extend the circulation and use time of fiscal funds without having to be recovered within just two years.
It's worth noting that after the introduction of the new Budget Law, the state issued multiple documents separating local financing platform companies from local governments. From January 1, 2015, their new debts are legally not considered local government debt. This situation forced local governments to start using guided funds to leverage social capital.
As mentioned in the book "Embedded Power: Chinese Government and Economic Development"(置身事内), before the budget law reform, local governments often used various special funds set up within the budget to attract investment and provide subsidies to enterprises. After the reform, the State Council began to strictly limit local government fiscal subsidies to enterprises. These fiscal funds, originally used for subsidies and tax incentives, had to find new carriers and outlets. Unlike non-recoverable fiscal subsidies in investment attraction, funds invested in guided funds can be withdrawn, allowing government fiscal funds to be recovered and recycled, thus directing a large amount of fiscal funds towards guided funds.
Finally, let's look at the assistance from state-owned enterprise reform. In 2015, in the "Guiding Opinions on Deepening the Reform of State-owned Enterprises," the state first proposed the transformation of state-owned asset supervision functions from "managing enterprises" to "managing capital." In 2018, the State Council issued a document further clarifying that state-owned capital operation companies should "revitalize existing state-owned assets, guide and drive social capital to develop together, and achieve reasonable flow and value preservation and appreciation of state-owned capital" through "fund investment and other methods." The reform of state-owned enterprises managing capital, on the one hand, made state-owned assets an important component of government-guided funds; on the other hand, it also promoted the establishment of state-owned capital operation companies. For example, Beijing Guoguan was entrusted to manage major funds such as the Beijing Municipal Government Investment Guided Fund, Urban Sub-center Construction and Development Fund, and Jingguorui SOE Reform and Development Fund, participated in the establishment of funds like the Beijing Science and Technology Innovation Fund, with a total fund management scale of 200 billion yuan. In addition, Shanghai Guosheng, Guangdong Hengjian, and others were entrusted to establish fund ecosystems with subscribed scales of over 100 billion each.
Under multiple drivers, the scale of government-guided funds expanded rapidly after 2015. According to Qing Ke data, before 2014, government-guided funds were in a state of slow growth. By 2015, the target scale had reached 1.6 trillion yuan, far exceeding the total market stock before 2015. The target scale in 2016 doubled compared to 2015, exceeding 3.4 trillion. After 2017, the growth rate showed a year-on-year decline trend, with existing funds gradually moving towards integration and optimization. By the end of 2022, China had established 2,107 government-guided funds, with a target scale of about 12.84 trillion yuan and a subscribed scale of about 6.51 trillion yuan.
II. The Multiple Roles of the State in Government-Guided Funds
(1) Attracting Capital: The State as an Institutional Practitioner in the Rise of Guided Funds
During the initial exploration, formal regulation, and explosive growth periods, the state provided continuous institutional support for the rise of government-guided funds at both the capital market and local innovation levels.
From the perspective of the capital market, the state continuously improved the investment environment. First, the state laid the institutional foundation for the equity investment market by establishing and improving the legal system and constructing a multi-level capital market system. Between 1992 and 2008, the state continuously explored the establishment of supporting systems for the equity investment market, introducing the "Trust Law," "Company Law," "Securities Law," and "Fund Law," establishing the legal status for private equity funds. The equity division reform in 2005 eliminated the institutional differences between non-tradable and tradable shares. The 2006 "Company Law" reform on venture capital funds led to a peak in domestic venture capital growth. Second, China's exchanges have been continuously reforming to promote the development of venture capital institutions. The SME Board and ChiNext of the Shenzhen Stock Exchange opened in 2004 and 2009 respectively. The New Third Board market began expansion in 2013, the STAR Market of the Shanghai Stock Exchange was implemented in 2019 with registration system reform, and the Beijing Stock Exchange also opened in 2021. Around 2014, with the continuous improvement of exit channels in the multi-level capital market, the implementation of the new Budget Law, the promotion of the "mass entrepreneurship and innovation" policy, and the restart of domestic A-share IPOs, domestic equity investment fund institutions developed rapidly.
Under the state's multiple drivers, various regions launched extensive and diverse institutional practices, making the development of high-tech industries an important local performance metric, promoting the integration of capital, technology, and markets. The CVsource database shows that national-level guided funds account for only 1.50% of the total number, while provincial, municipal, and district/county-level government-guided funds account for 24.31%, 53.4%, and 20.78% respectively, with scale proportions of 38.44%, 42.69%, and 11.40%.
Specifically, as an industrial center in the Yangtze River Delta, Suzhou began exploring government-guided funds as early as 2011. Subsequently, Suzhou took the lead in establishing an information management database for government-guided funds and promptly issued fund management measures and related rules; based on the industry characteristics and investment areas of the funds, it formulated effective standard texts such as legal texts for parent fund partnership agreements and fund operation report guidelines, creating a legal protection environment; it explored assessment and evaluation systems, put forward risk control requirements for fund managers and custodian banks, and formulated diversified exit plans; and so on.
Another example is Hefei, which created the "Hefei Model" through unique institutional practices in its investment processes in BOE, Changxin Memory, NIO, and others to break free from the development dilemma of being the "largest county-level city." The success of this model is inseparable from the following steps: First, the government forms professional market investigation teams to proactively seek out and invest in quality projects, creating markets; Second, it leverages the leading investment role of state-owned asset platforms in high-tech industries, promotes project landing, and improves the cyclic development model of state-owned equity exit; Third, on the basis of parent funds, it encourages angel (seed) funds to "invest small, early, and in technology," with market-oriented funds taking over when development matures, forming a staged, chain-like investment fund cluster; Finally, the government establishes a science and technology innovation committee, relying on local university research institutions to promote innovation.
Jiangxi, once viewed as an "investment desert," has been accelerating its investment layout around high-tech industries since 2022. The Jiangxi government not only promulgated implementation plans for industrial investment platforms and modern industrial development guided funds; the government leadership group also promotes market-oriented operation and professional management through high-level promotion, relying on Jiangxi State-owned Assets Control. Thus, its industries can rely on resource endowments such as non-ferrous metal smelting, building materials, and equipment manufacturing, seeking market resources from the Yangtze River Delta and Guangdong-Hong Kong-Macao Greater Bay Area externally, accelerating the landing of fund projects in new energy, aviation, electronic information, and other industries.
(2) Negotiating with Capital: The State as an Investor in Market-oriented Operation of Fiscal Funds
Government-guided funds differ from fiscal funds in previous investment attraction efforts. Although they are essentially public fiscal funds, they also enter the market in the form of capital. In this process, the state acts as an investor in the market-oriented operation of fiscal funds, and this dual identity provides many benefits for the efficient operation of funds.
Firstly, the government has expanded funding sources for high-tech industries by replacing debt financing with equity financing. As guided funds mostly adopt a "parent fund + sub-fund" two-tier structure, sub-funds are fully or partially funded by parent funds, and both parent and sub-funds can introduce social capital investors to invest in high-tech industry projects, thereby maximizing the leverage of social capital. In the private equity market, the government rarely invests alone, with its share generally not exceeding 30% of the fundraising amount, relying on cooperation with social capital to complete the fundraising. The funding sources for guided funds include government agencies, financial institutions, enterprises, private equity/venture capital (PE/VC), fund of funds (FOF), pension funds, insurance funds, family wealth funds, and individuals, relatively reducing the financial pressure of government solo debt financing in the past.
Secondly, indirect investment through guided funds relatively eases government management pressure. The investment methods of government-guided funds are divided into "indirect equity investment" and "direct equity investment." Under the indirect investment method, the government applies modern enterprise systems and governance structures, specifically divided into three organizational structures: limited partnership, corporate, and contractual, with limited partnership being the main form in practice. Limited partnerships consist of Limited Partners (LP) and General Partners (GP). The government plays the role of LP as an investor, not participating in daily operations and management; market fund management institutions play the role of GP, with investors giving GP management fees and performance bonuses while bearing limited liability, and GP is responsible for daily affairs management and bears unlimited joint liability. This mode of operation reduces the administrative management burden of the government, which is solely taking on major responsibilities in previous investment attraction efforts.
In the direct investment of guided funds, the government plays a more direct management role. The direct investment forms of government-guided funds have developed, extended, and innovated in recent years, such as follow-up investment, establishment of special sub-funds (investing only in certain types of projects), etc., directly supporting key projects and accelerating project implementation. A research institution has compiled statistics on 20 newly released and revised government-guided fund management measures in 2022, of which 70% of government-guided funds can adopt direct investment methods, a significant increase compared to 40% before 2022. This reduces the leverage amplification effect of fiscal funds leveraging social capital and poses higher challenges to the bureaucratic capabilities of government fund management teams, such as professional direct investment experience and identifying quality projects.
Specifically, at the central level, different departments take on the responsibility of managing the government-guided funds they create. For cases where the State-owned Assets Supervision and Administration Commission, Ministry of Industry and Information Technology, Ministry of Science and Technology, State Administration for Industry and Commerce, and state-owned enterprises lead or jointly initiate guided funds, the corresponding supervising departments of these parent funds must assume management functions. At the local level, local governments often establish working groups that are responsible for the operation and management of funds while also cooperating and participating in local fund supervision work.
(3) Regulating Capital: The State as a Supervisor in Standardizing Government-Guided Funds
From the perspective of horizontal departmental relationships, government-guided funds are subject to multiple regulatory oversights from the state:
First, government-guided funds have the nature of equity investment funds and are classified as private equity investment funds. According to the "Fund Law," they should be supervised by the China Securities Regulatory Commission (CSRC). Additionally, the China Banking and Insurance Regulatory Commission (CBIRC) (merged into the National Financial Regulatory Administration in May 2023) is responsible for supervising financial institutions and regulating illegal behaviors in the process of fund-raising for guided funds, to avoid and prevent systemic financial risks arising from various types of capital entering fund operations.
Second, guided funds mainly invest in high-tech industries and have industrial fund attributes. This means they must comply with the industrial management regulations of the National Development and Reform Commission (NDRC). The NDRC stipulates the key industrial investment directions for guided funds to ensure alignment with the national asset investment layout for high-tech strategic enterprises. The NDRC has established a credit registration system for industrial investment funds from national to local levels, issued negative lists, defined investment areas, and adopted performance evaluation and reward-punishment mechanisms. The annual business, financial, and custodian situations of industrial investment funds established by government departments and their directly affiliated institutions from central to local levels must be reported to the NDRC at their respective levels.
Third, government-guided funds have fiscal fund attributes and are therefore also subject to supervision by financial and audit departments. Furthermore, publicly available anti-corruption reports show that the state's party discipline departments and disciplinary inspection departments have also begun to intervene in the supervision of guided funds in recent years, becoming another regulatory force.
From the perspective of vertical block relations, local NDRC and finance departments are localized management departments, while the "one bank, three commissions" are under central vertical management. The main change in the block relationship lies in local financial regulatory departments. The 2017 National Financial Work Conference emphasized strengthening local risk disposal responsibilities under unified central rules while maintaining that financial management is primarily a central authority. Subsequently, following the spirit of the Central Economic Work Conference, the State Council issued "Opinions on Serving the Real Economy, Preventing and Controlling Financial Risks, and Deepening Financial Reform." Many local financial offices, originally public institutions, gradually developed into local financial regulatory bureaus with supervisory functions responsible for regulating "7+4" types of financial organizations. Until the 2023 institutional reform, a local financial regulatory system was established, mainly based on local branches of central financial management departments, with financial regulatory power decentralized.
III. Multiple Logics of the State in Government-Guided Funds
Guiding the development of high-tech industries is an important goal of government-guided funds. However, in the operation process of guided funds, the state's multiple roles mean that it also has multiple objectives: government-guided funds often need to not only achieve high-tech industrial development but also balance market returns, fiscal fund safety, preservation and appreciation of state-owned assets, local development, officials' performance, and effective supervision. It's worth noting that there are often tensions between these multiple objectives, forming multiple logics in the operation of guided funds.
First, there is tension between the demand for market returns and industrial development goals. Guided funds need to balance the relationship between short-term returns on capital and the long-term goals of national industrial development. On one hand, guided funds are long-term investment cycle national strategic investments. Most government-guided fund investors (LPs) will first consider policy goals in their evaluation criteria for fund managers (GPs), such as whether the investment aligns with high-tech industrial policies and the leverage ratio of fiscal funds. Furthermore, the government's evaluation results will affect the fund's capital adjustment and GP's fund management fees, which forces the GP's management focus to prioritize the government LP's investment attraction tasks. On the other hand, guided funds are also market-oriented capital with the inherent nature of capital to pursue profits and appreciation, needing to meet social investors' short-term return demands. GPs also need to consider investment risks and returns from a professional private equity management perspective and select investment projects based on market conditions. In this situation, conflicts of goals between the government and fund managers can easily arise, potentially discouraging social capital from participating in guided fund operations.
Second, there is tension between the preservation and appreciation of fiscal funds and state-owned assets and the investment risks of guided funds. The operation of large-scale state-owned LPs in the capital market carries risks to market stability and the preservation and appreciation of national fiscal and state-owned capital if investments fail. In over twenty years of implementing government-guided funds in China, there have been cases of investment management failures in both national and local-level funds. For example, executives of national-level funds like the National Integrated Circuit Industry Investment Fund and China Government and Social Capital Cooperation Fund have been investigated by the Central Commission for Discipline Inspection due to corruption issues. Some local-level funds have stagnated due to a lack of social capital cooperation, weak industrial foundations, and outdated management methods, resulting in the loss of local state-owned assets. Currently, governments at all levels are accelerating the improvement of performance evaluation systems and error-tolerant mechanisms for cadres' "duty performance without liability." In the future, it will be necessary to improve the market-oriented exit mechanisms for guided funds, including setting up Secondary Funds (S Funds), and transferring or exiting guided fund shares according to market standards or preferential standards.
Third, there is tension between government administrative management and the market-oriented operation of funds. In indirect investments, the state still needs to guide and supervise the operation of GPs in general directions, setting up fund management institutions to interface with market GPs and custodians to ensure the realization of the fund's policy objectives. This greatly tests the professional capabilities of government management personnel. For example, in the distribution and incentivization of fund management fees, if the threshold for local performance rewards is unreasonable, it may lead to insufficient work motivation for professional managers or moral hazards and rent-seeking behaviors such as GPs extracting additional management fees. At the same time, the return on investment in high-tech industries through guided funds is a long-term process, and it's difficult to set evaluation standards for potentially promising enterprises. How to set sustainable, quantifiable medium and long-term assessment targets for management teams and improve the "duty performance without liability" mechanism is also a major challenge.
Fourth, there is tension between local government returns and the borderless flow of capital. Local governments impose reinvestment ratio requirements on fiscally funded funds, which is a key point of capital negotiation between government investors (LPs) and market managers (GPs). As investors, local governments still hope that guided funds can primarily serve local economic, social, and political needs, becoming a policy tool to assist local investment attraction. However, the nature of capital flow and profit-seeking does not want to be restricted by local government territorial limitations. Seemingly favorable policies and conditions can be borne by economically developed regions with strong industrial foundations and capital strength. However, regions with weak industrial foundations and tight fiscal resources that blindly offer generous policies and conditions may exacerbate local government fiscal burdens and implicit debt predicaments.
Fifth, there is tension between local economic development and national financial supervision. The block-and-line relationship of local financial regulatory departments will affect the balance between their development and regulatory functions. For a long time, local government financial offices have been responsible for providing financial services and promoting local financial development. There is considerable tension between this development task and strengthening local financial supervision. Until the 2023 institutional reform, local financial regulatory bureaus no longer carry additional titles, such as financial work bureau and financial office, aiming to strengthen the central authority of financial supervision. However, for local governments, balancing the financial supervision of guided funds with the dual goals of using guided funds to promote high-tech industrial development remains deeply challenging in practice.
IV. Summary
Capital is an important driving force for industrial development, and different countries have varying models for acquiring capital input for industrial development. In the Anglo-American model, known as "stock capitalism," industrial development relies on "financialization" or "stockification," mainly obtaining funds from stock and other market financial products, with less dependence on bank finance and relatively less bank involvement in industrial management. In Germany, industrial capital relies on financial capital input from banks, with three comprehensive banks represented by Deutsche Bank having extensive institutional connections with the industrial sector, enabling fine control over the operation of industrial capital at the microeconomic level. In France, industrial development also heavily relies on long-term bank borrowing; at the same time, French Treasury officials can exert significant influence on Banque de France's behavior, directing scarce funds to key industrial sectors, thus achieving strong government intervention in the banking sector. In Japan, the industrial sector has formed a cross-shareholding capital model rooted in the panic of being massively acquired by American companies triggered by stock market fluctuations in the early post-World War II period. Under this conceptual inertia, the cross-shareholding of most large Japanese companies ensures the stability of shareholders and capital structure to avoid bankruptcy and mergers and acquisitions.
In China, although the state has considerable dominance over bank credit under the "internal market," and the government is accustomed to using direct fiscal subsidies as an industrial policy, overly localized industrial policies have not highlighted the driving force of capital elements for high-tech industrial development. In the gradual reform process, China's main industrial force remains a large number of small and medium-sized enterprises growing from grassroots. Over the past two decades, the rise of stock and capital markets has begun to provide capital driving force for industrial development, but still faces the problem of lacking patient capital, especially for China's late-comer technological catch-up, relying on the market to provide patient capital is even more difficult.
Various government-guided funds that have rapidly developed by leveraging capital with the "state hand" have amplified the role of capital elements in promoting high-tech industrial development, constituting China's practice of capital elements and high-tech industrial development. In this process, we can see that leveraging capital with the "state hand" to guide high-tech industrial development has achieved multiple drivers, and the state has multiple identities and multiple action logics in it. These multiple drivers, multiple identities, and multiple logics create multiple uncertainties as to whether leveraging capital with the "state hand" can effectively guide high-tech industrial development. In the future, China needs to explore further how to realize the capital driving force for high-tech industrial development effectively.