In early 2020, as the pandemic pushed it to the verge of bankruptcy, China’s highest-profile rival to Tesla was shunned by the venture capital funds and foreign investors that had powered its rise. So Nasdaq-listed Nio turned to China’s newest class of venture capitalists: Communist officials.
The municipal government of Hefei, a city in eastern China, pledged $787 million to acquire a 17% stake in Nio’s core business. The company moved key executives from Shanghai to the city, which is less than half the size and 300 miles inland, and began producing more vehicles there. The central government and Anhui, Hefei’s province, joined the city, making smaller investments.
It might look like the kind of power grab some observers see as characteristic of President Xi Jinping’s China: an assertive state enforcing an ever-growing list of dictates on innovative private companies that are destined to discourage entrepreneurship. But the story didn’t play out that way.
Nio turned its first profit in early 2021 and sold more than 90,000 vehicles by the end of the year. Rather than leveraging its stake to assert control, the Hefei government took advantage of Nio’s booming share price to cash out most of its stake within a year of its purchase — making a return of up to 5.5 times its investment — much like a private investor in London or New York might have done.
“From our investment in Nio, we ruthlessly made money,” Yu Aihua, the top Communist official in the city, said at a televised event in June that saw him seated on a podium dressed in a business suit and purple tie with entrepreneurs including Nio’s founder, William Li, seated below.
“Making money for the government is not an embarrassment: It’s making money for the people,” he added.
Hefei has pioneered a shift in Chinese capitalism over recent years in which local governments are increasingly taking minority stakes in private companies. Since the 1950s, Hefei has been a hub of scientific research, but today its shrewd investments have transformed it from a relative backwater to a bustling metropolis of about 5 million people. In terms of economic growth, what Chinese media call the “Hefei model” appears to work. In the 2010s, Hefei was China’s fastest-growing city in terms of gross domestic product.
“White knights”
China’s local governments control land sales, receive profits from state-owned companies, and have close ties with state-owned banks. For decades they have supported private companies by offering them cheap land and other subsidies, tax breaks, and loans to encourage investment. That’s helped local officials, largely judged on the basis of economic performance, to win promotion from the ruling Communist Party.
More recently, that model has been updated for an era that depends on technology investment and innovation for growth.
As China’s economy slows and Beijing tries to rein in debt, cash-rich local governments and state-owned companies have emerged as “white knights,” rescuing troubled private companies. In many cases, local governments are taking a passive approach to these investments, with a growing number of stakes taken through funds instead of through direct holdings.
Today, Hefei invests in dozens of companies that are working on semiconductors, quantum computing and artificial intelligence. Those industries are at the center of the Communist Party’s plans to double the size of China’s economy by 2035, likely overtaking the U.S. along the way. The Hefei model, and other cities’ efforts to replicate it, will be crucial to determining if that ambition is realized.
Hefei made its first winning bet on BOE Technology Group, an electronic-display maker founded in 1993. When BOE was in trouble after the 2008 financial crisis, the city canceled plans for its first subway line and instead plowed billions of yuan into the company on the condition it would build a local plant. BOE built a state-of-the-art LCD screen plant, and by 2011 Hefei owned an 18% stake. The city agreed to vote with management on key decisions, according to company filings.
Over the following years, Hefei continued to invest in BOE, helping it build new plants and extracting profits. The company brought tens of thousands of jobs to Hefei and anchors a display-industry manufacturing cluster that makes products worth more than 100 billion yuan annually, including for foreign companies such as Corning. In 2021, BOE overtook South Korea’s Samsung Electronics as the world’s top manufacturer of LCD screens used in flat-screen TVs, helping end China’s dependence on foreign suppliers.
Academics have only recently been able to quantify how this model is transforming China’s economy. Researchers at the University of Chicago, Tsinghua University in Beijing, and the Chinese University of Hong Kong analyzed every registered company in China — more than 37 million of them. They found that those companies are ultimately owned by 62 million private individuals — essentially the complete list of China’s capitalists — as well as about 40,000 state agencies from the central government down to cities and even villages.
Companies owned by state agencies, most at the local-government level, have been increasing their partnerships with private companies. The average state stakeholder now invests in companies owned by almost 16 private owners, up from eight a decade ago. Since the average number of owners per company is constant, this indicates each state stakeholder has nearly doubled the number of private companies it invests in over that period, says Chang-Tai Hsieh, a professor at the University of Chicago’s Booth School of Business and a researcher on the project.
As a result, China’s biggest entrepreneurs are more connected with the state.
In 2019, of the 7,500 wealthiest individual owners, just over half had at least one business that included a state agency among its investors. The trend results in companies that are “not fully state-owned firms but also not really private firms,” Hsieh says. “It’s this murky gray area, which I think is the dominant corporate structure in China today.”
Take China’s six largest electric vehicle startups, which collectively sold more than 435,000 cars in 2021. Five have local governments as minority investors. The investments are often held by companies that are themselves owned by local governments.
“Thirty years ago [state government-owned companies] produced stuff that nobody wanted to buy. Now they are more like venture capital firms,” Hsieh says.
Driving growth
For entrepreneurs, forming partnerships with local governments makes it easier to get approvals for new factories, licenses to do business, and financing from the state-dominated financial system, and it can offer a degree of political protection. Hsieh and his co-authors estimate that such hybrid companies account for the bulk of the growth in China’s economy over the last decade. A key to their success: The founding entrepreneurs remain in charge of important business decisions and respond to the market rather than political dictates.
The U.S. and other Western governments have long been wary of the economic power of China’s “state capitalism,” fueled by giant state-owned companies and an industrial policy driven by subsidies and government mandates. But what’s really propelling China’s growth is private firms with minority government-linked investments. “The distinction between state-owned and private has been important for policymakers outside China and for analyzing the Chinese economy,” says Meg Rithmire, a professor at Harvard Business School who specializes in comparative political development in Asia and China. “That boundary is eroding.”
Other developing countries have taken strategic stakes in private companies on a large scale to ease economic and social turbulence. Rithmire points to Brazil, following macroeconomic shocks in the 1980s, and Malaysia, which in the ’70s began a multidecade project of acquiring business stakes as part of a campaign to boost the economic influence of ethnic Malays in the country. In both cases, she says, the government used the stakes to gain increased influence on business decisions, which led to wasteful investment and ultimately did little to support growth.
Government investments can lead to the kind of conflicts of interest typically discouraged at U.S. businesses. Hefei invested in Nio in part to shore up another of its holdings: Anhui Jianghuai Automobile Group Holdings, known as JAC Motors, which had rented a huge production line to the private EV maker.
City-financed investment funds are buying foreign companies, too. In 2016, Beijing Jianguang Asset Management Co., known as JAC Capital, paid $2.75 billion for Dutch chipmaker Nexperia, which produced semiconductors used in mobile phones. Two years later, the fund, which includes Hefei among its investors, sold its stake to Chinese chipmaker Wingtech for $3.6 billion. Hefei has a 4% stake in Wingtech. Wingtech made headlines in the U.K. last year, when one of its subsidiaries bought the troubled Welsh semiconductor manufacturer Newport Wafer Fab for $87 million.
Meanwhile, even after Hefei sold most of its Nio stake, the city’s investment in EV technology continues to pay off. Germany’s Volkswagen AG has acquired 50% of JAC Motors and a 26% stake in battery maker Gotion High-tech, as it turns Hefei into one of its main production bases. Erwin Gabardi, chief executive officer of Volkswagen Anhui, praised the region’s “entrepreneurial spirit” and policy support. “This is why Volkswagen chose Hefei,” he says.
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