Shanghai shows how not to start a start-up culture

"Risk-averse venture capitalist" may 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 of up to six million yuan (S$1.3 million) per year, incurred by 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 is not 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 nothing less than 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 all that much difficulty attracting venture capital right now. Chinese start-ups attracted US$41.8 billion (S$59.8 billion) in investments last year, according to Tech In Asia, while the rest of Asia received US$13.5 billion. Good data on start-ups and venture capital funding is thin in China, but what exists suggests that Shanghai is trailing behind. Last year, PwC reported that Shanghai start-ups received only 18 per cent 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 internationalisation and economic reform.

The truth is that, despite its sparkling free-market reputation, Shanghai has long lagged behind 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 have 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. That preference for the state sector has not abated: When deciding how to redevelop Shanghai's 2010 World's Fair grounds, the government designated much of the extraordinarily valuable land as a new headquarters for - yes - state-owned companies.

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 US$16 trillion in assets, 17 per cent of urban employment, 22 per cent of industrial income and 38 per cent of China's industrial assets. Their activities range from steel to hotels, and entrepreneurs who dare compete with them for business or 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 favoured the development of a healthy private sector over state-guided capitalism, while supporting privatisation of state companies. Meanwhile, Shenzhen's government - realising that entrepreneurship will be key to the region's future - has been proactive in creating loan programmes 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 will not be easy or quick, for Shanghai or anyone else. Shenzhen's unique industrial eco-system developed over three decades, and it's not without its own problems (including dangerously lax safety oversight).

But the main lesson should not be lost on Shanghai or any other Chinese city: The key to innovation isn't venture capital bailout funds or other quick fixes that draw on China's deep pockets. Rather, entrepreneurs need the certainty that they will 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.

BLOOMBERG

A version of this article appeared in the print edition of The Straits Times on February 04, 2016, with the headline 'Shanghai shows how not to start a start-up culture'. Print Edition | Subscribe