How not to start a start-up culture

“Risk-averse venture capitalist” might sound like a contradiction in terms, but in Shanghai, it’s precisely the sort of financier the city is looking to attract. Starting Feb. 1, the city plans to reimburse venture capitalists for losses up to 6 million yuan ($912,000) per year, incurred investing in the city’s early-stage start-ups. The policy is intended to accelerate Shanghai’s transformation into a science-and-technology hub of “global influence.”

Shanghai isn’t alone among Chinese cities in seeking to develop a start-up culture. As the Chinese economy slows, that quest has become a near-obsession for the government, with China’s top policymaking body calling for a wave of “mass entrepreneurship and innovation” across the country. But as the recent debacle in Shanghai’s stock market has amply demonstrated, bailing out investors from the consequences of their decisions isn’t the way to develop a vibrant and resilient economy.

In fact, Chinese companies don’t have much all that much difficulty attracting venture capital right now. In 2015, Chinese start-ups attracted $41.8 billion in investments, according to Tech in Asia, while the rest of Asia received $13.5 billion. Good data on start-ups and venture capital funding are thin in China, but what exists suggests that Shanghai trails. Last year, PwC reported that Shanghai start-ups received only 18 percent of “total deal volume” from venture capital and private equity investing in China. That surely annoys Shanghai’s city fathers, who have promoted the idea that Shanghai stands in the vanguard of China’s internationalization and economic reform.

The truth is that despite its sparkling free-market reputation, Shanghai has long lagged the rest of China in promoting entrepreneurship. According to a groundbreaking 2010 study, Shanghai underperformed 125 other Chinese cities in the overall density of private firms (defined as the number of private firms divided by city population), giving it “an unexpectedly low level of entrepreneurship.”

Instead, buoyed by central and local industrial policy, the city’s state-owned firms have largely driven its prosperity. They’ve also depressed entrepreneurship in key sectors. According to the 2010 study, private Shanghai companies competing against state-owned counterparts were smaller than in 150 other cities with similar conditions.

The state sector’s influence remains dominant across China, of course. The central and local governments own some 155,000 enterprises, which together account for $16 trillion in assets, 17 percent of urban employment, 22 percent of industrial income and 38 percent of industrial assets. Their activities range from steel to hotels, and entrepreneurs who dare compete with them for business or for bank loans (from China’s state-owned banks) do so at some risk. Until that changes - and the government’s plan to “reform” state-owned enterprises actually looks to strengthen their role in the economy - efforts to increase innovation will struggle.

The good news is that in Shenzhen, China has found a model for getting around this problem. Founded as China’s first special economic zone, the city’s leadership has always favored the development of a healthy private sector over state-guided capitalism, while supporting privatization of existing state companies. Meanwhile, Shenzhen’s government has been proactive in creating loan programs for small and medium-sized enterprises. Shenzhen has also been unusually supportive of the small-scale maker movement, supporting the development of several low-cost co-working spaces for entrepreneurs as well as large-scale international events to highlight the area’s maker community. (Shenzhen is host to Asia’s largest “maker faire.”)

Replicating Shenzhen’s success won’t be easy or quick, for Shanghai or anyone else. Shenzhen’s unique industrial ecosystem developed over the course of three decades, and it’s not without its own problems (including dangerously lax safety oversight). But the main lesson shouldn’t be lost on Shanghai or any other Chinese city: The key to innovation isn’t venture capital bailout funds or other quick fixes that leverage China’s deep pockets. Rather, entrepreneurs need the certainty that they’ll be competing against each other and not bureaucrats. The Chinese government would be better off creating an environment to promote that kind of open and even-handed competition, and letting markets sort out the winners and losers.

*The author is an American writer based in Asia, where he covers politics, culture, business and junk.

by Adam Minter