The municipal government of Hefei, a city in eastern China, pledged 5 billion yuan ($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 decade to 2020, Hefei was China’s fastest-growing city in terms of gross domestic product.
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 Co., 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 liquid-crystal display (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 Inc. In 2021, BOE overtook South Korea’s Samsung Electronics Co. as the world’s top manufacturer of LCD screens used in flatscreen 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 (judged by the size of invested capital in the companies they own), 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, according to corporate records. The investments are often held by companies that are themselves owned by local governments. “Thirty years ago they [state government-owned companies] produced stuff that nobody wanted to buy. Now they are more like venture capital firms,” Hsieh says.
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 US 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 policymakers need to pay more attention to what’s really propelling China’s growth: 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.
As is often the case with venture capital, many government investments flop. These include some of Hefei’s earliest forays, such as a solar panel company and a 2 billion-yuan acquisition of a plasma screen factory from Japan’s Hitachi Ltd., both of which proved uncompetitive. In 2017 the government of Wuhan, the capital of Hubei province, took a 200 million-yuan stake in Wuhan Hongxin Semiconductor Manufacturing Co. The company aimed to generate annual sales of 60 billion yuan once running at full capacity. Last year the project was dissolved without making a single chip.
If one key to successful state investment is avoiding political interference in decision-making, as both Rithmire and Hsieh indicate, then the move by China’s local governments to employ professional fund managers could be an important step. Since 2015, Chinese officials have set up private equity-style “funds of funds” worth 2.14 trillion yuan, according to CVInfo, which provides information on China’s private equity industry.
Their managers invest in smaller funds, pooling cash with state-owned or private companies. Some funds are dedicated to supporting mature companies, and others are responsible for “angel” investment in startups. Typically, the government fund plays the role of limited partner in the lower-level funds, delegating investment decisions to a general partner—often a local state-owned company with industry expertise.
Government officials typically have little day-to-day control over the lower-level funds. “Local governments thought it was a good idea to find professional managers to help them choose companies,” says Liu Jingkun, an analyst at CVInfo.
These funds are major investors in the technology industry. In 2019, when China set up the Star board, modeled on the US’s tech-heavy Nasdaq Stock Market, 14 of the original 25 listed companies reported state-owned minority investors. For example, Advanced Micro-Fabrication Equipment Inc.’s largest shareholder, with a 20% stake, was Shanghai Venture Capital, owned by that city’s government. (Today it owns 15.6%.)
The Hefei government has also shifted to investing through dozens of funds, a single one of which can manage assets as large as 31 billion yuan. Hefei’s early stakes in companies such as BOE were held directly, but its stake in Nio is currently held by a fund.
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 Ltd., known as JAC Motors, which had rented a huge production line to the private EV maker.
Such ventures show that local government investments are often less about a bold vision for the future and more about preventing the collapse of large companies and the resulting financial and social instability, says Harvard’s Rithmire. “I caution against seeing strategic coordination in everything Chinese funds and firms do.”
Hefei’s success has inspired officials in cities as far afield as Inner Mongolia. Even Shenzhen, China’s leading tech hub, is taking note: The city’s Guangming District vowed last year to “study and explore” Hefei’s example. Given China’s size, if the model is even a partial success, it could transform the global economy for decades to come.
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 Co., 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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