How to kill Chinese dynamism


There are rough times ahead for China as its entrepreneurs stop registering assets in Hong Kong

In Lonely Ideas: Can Russia Compete?, MIT historian of science Loren Graham shows that many technologies pioneered by Soviet and post-Soviet Russia — including various weapons, improved railroads and lasers — nonetheless failed to benefit the national economy in any substantial way. The reason for this abysmal failure, he concludes, is Russia’s lack of entrepreneurship.

The same insight can be applied to Imperial China. Many ideas that originated there were lonely orphans and brought little to no benefit to the Chinese economy. By contrast, the China of the post-1978 reform era moved in an altogether different direction from both Russia and China’s own pasts. As the reforms took root and blossomed, China began to develop a large, dynamic private sector with many entrepreneurs who were highly motivated and capable of bringing technologies to scale.

Chinese ideas and innovations were no longer lonely but had quite a lot of company. More importantly for China’s economy, they were regularly deployed to generate growth, employment and the tax revenues that helped keep the Chinese Communist Party (CCP) in power.

Illustration: Yusha

Imperial China was inventive, but it was not innovative. As the late economist William Baumol showed, this distinction is crucial. Inventions alone do not contribute to economic growth. Rather, growth is powered by innovation — the entrepreneurship and business-development activities that take inventions to the market through commercialization. Capitalism is an innovation machine because it provides the mechanisms needed to turn inventions into economy-boosting innovations.

Under a reformist CCP, China became such an innovation machine. Yet China’s vibrant high-tech sector remains puzzling to many.

In their best-selling 2009 book, Startup Nation: The Story of Israel’s Economic Miracle, journalists Dan Senor and Saul Singer show how a culture of informality, risk-free inquiries and organizational egalitarianism — all supported by government policies and programs — helped make Israel a global entrepreneurial success story. The authors offer vivid details of subordinates pushing back against their superiors, even in the military — an institution synonymous with hierarchy.

China, by contrast, is top-down, hierarchical and repressive, stifling individual initiative. It seems to lack Israel’s culture of democracy, rule of law and protection of property rights. Chinese laws place no meaningful constraints on Chinese leaders, and Chinese finance is dominated by the statist banking system. While venture capital (VC) grew exponentially in the first two decades of the 21st century, big tech companies such as Alibaba, Huawei and Lenovo were not funded by Chinese VC in their startup phase.

China thus represents the polar opposite of Israel. Yet, China too, became a startup nation. Chinese entrepreneurship has flourished even without the rule of law and market-based finance, and despite autocracy being widely assumed to be antithetical to innovation. What explains this outcome?

The China Conundrum

Among commentators and scholars, there is a deeply rooted view that China has discovered and crafted “a third way” to foster dynamic innovation: a development model that harnesses the efficiency of the market economy and the power of the state without having to rely on the institutional prerequisites of capitalism, such as rule of law and market finance. I disagree. In my new book, The Rise and Fall of the EAST: How Exams, Autocracy, Stability, and Technology Brought China Success, and Why They Might Lead to Its Decline, I show that Hong Kong, at least until very recently, functioned as a hidden-in-plain-sight source of rule of law and market finance for many high-tech entrepreneurs in China.

Though China does not have rule of law and market finance, it effectively outsourced those functions to Hong Kong after Deng Xiaoping (鄧小平) succeeded Mao Zedong (毛澤東) and launched China’s reform era. Consider the history of the global computer giant Lenovo. Founded in 1984 under the auspices of the Chinese Academy of Sciences (CAS), its business was domiciled in Hong Kong from 1993 onward, a move that played a vital role in the company’s early development.

Acquiring the ability to tap into Hong Kong’s finance was a major milestone in Lenovo’s rise. After the initial funding it received from the CAS, the company raised much of its initial financing in Hong Kong’s conventionally Western capital market, both during its startup phase and through subsequent rounds of capitalization as it grew.

In 1988, Lenovo received HK$900,000 (US$115,000 at the current exchange rate) from China Technology, a Hong Kong-based firm, to invest in a joint venture in Hong Kong. Then, in 1994, Lenovo went public on the Hong Kong Stock Exchange, raising the funding needed for the company’s investments in China. Statist Chinese finance was nowhere to be seen.

Hong Kong was still a British colony in 1994, and from 1997 to 2019, it operated under the “one country, two systems” formula. Though the territory was under Chinese sovereignty, it preserved its legal and operational autonomy as a historically laissez-faire economy with a market-oriented financial system, rule of law and secure property rights. China did not furnish any of these core functions, but its reformist government made them available to some of its entrepreneurs.

This new access to growth-enhancing institutions was an unheralded and, most likely, unintended effect of the open-door policy that Deng had initiated. That policy’s big contribution lay not just in allowing foreign companies to establish factories in China, but, crucially, in linking Chinese entrepreneurs with global venture capital and in allowing some Chinese citizens and businesses to exit. China’s own capable entrepreneurs were given a way out of a very bad system. Let us get this straight: China’s success has less to do with creating efficient institutions than with providing access to efficient institutions elsewhere.

Outsourcing the Rule of Law

Those who believe that Chinese entrepreneurship somehow thrived under a magical formula of statism thus ignore the role that Hong Kong — and a number of other overseas domiciles — played in providing the conventional pillars of innovation-driven economic growth. To appreciate this perspective, just imagine a scenario in which China had the same statist banking system and the same technical and entrepreneurial human capital, yet no Hong Kong at its doorstep. You would not see anything like Lenovo’s development story.

That is why it has been so common among Chinese high-tech firms to register their assets outside mainland China’s legal system. Within the BAT trio of Internet giants (Baidu, Alibaba and Tencent), only Tencent is registered in China (in Shenzhen). Incidentally, Tencent was backed early on by Naspers, a media company in South Africa. Alibaba Holdings, according to one registry, is registered in the Cayman Islands, though another registry shows that its Chinese operating unit was established in 1999 as a joint venture between a Hong Kong concern and a Chinese firm. Most likely, the Cayman unit established its Chinese operating unit through a holding company in Hong Kong.

Similarly, Baidu Holdings is registered in the British Virgin Islands and its Chinese operating unit, established in 2000, is a wholly owned foreign firm, with the same legal status as Lenovo Beijing and Lenovo Shanghai. The biggest facial-recognition firm in China, SenseTime (which the US government has blacklisted), and ByteDance, the ultimate holding company of TikTok, are registered in Hong Kong while China’s second-largest e-commerce company, JD.com, is registered in the Cayman Islands.

As journalist Mara Hvistendahl noted in late 2018, there are nine Chinese firms among the world’s 20 biggest tech companies, and only three of them are fully domiciled domestically: Tencent, Xiaomi and Ant Group (whose parent firm is foreign-registered). The other six — Alibaba, ByteDance, Baidu, Didi Chuxing, Meituan and JD.com — all have domicile connections to establishments registered in Hong Kong or other overseas territories.

Lonely Again

To be sure, Chinese high-tech entrepreneurs have also benefited from other factors, such as the scale advantage offered by millions of well-trained technical personnel and the growth opportunities associated with a rapidly increasing GDP. But access to the rule of law and market-based safe harbors such as Hong Kong and foreign localities was crucial. An underappreciated aspect of globalization is that it brought to China not only foreign markets but also propitious institutional conditions and global risk capital. We need to recognize this institutional effect to get the China story right.

This recognition exposes the inaccuracy of the view that China can do without efficient market-based institutions. Lenovo’s story is precisely about the importance of these institutions. The company was able to tap into these institutions because China was accidentally fortunate enough to border one of the world’s most laissez-faire economic systems. China is special not because it has cracked the code of state capitalism, but because its system has had an escape valve.

This is another reason we need to get the China story right. Other countries that want to foster entrepreneurship would be making a huge mistake if they tried to emulate China’s domestic financial and legal institutions and practices. As successful as Lenovo and other Chinese high-tech businesses are, the special circumstances around Hong Kong suggest that they do not represent a generally applicable model.

Sadly, many commentators and Chinese policymakers themselves do not seem to grasp this point. Jin Keyu (金刻羽) of the London School of Economics argues in her new book Beyond Socialism and Capitalism that China’s unique development model enabled its miracle growth without a need for Western contrivances such as the rule of law and market finance. She mistook the genuine enlightenment during the reform era that allowed Chinese entrepreneurs to circumvent a statist system for the virtues of that system. Remarkably, her book comes at a time of massive capital flight from China, much of it driven by Chinese entrepreneurs who fear for the security of their persons and property. The incongruity is jarring.

Similarly, in a 2019 commentary for the New York Times, Eswar Prasad of Cornell University argues that Hong Kong is no longer that important to China, because the Chinese economy now dwarfs that of Hong Kong. Whereas Hong Kong was one-fifth the size of the Chinese economy in 1997, he observes, it was only one-thirtieth the size in 2018.

Allow me to cite a different set of statistics. My book profiles three leading biotech firms in China: BeiGene, WuXi AppTec and Zai Lab. Not for nothing, all are registered in Hong Kong, like so many other Chinese high-tech firms. Imagine arguing that the US Constitution is useless because it has zero GDP. As flawed as it is, Prasad’s argument is revealing as an accurate reflection of how most China watchers have discounted the importance of the rule of law and market finance.

Is this how policymakers in Beijing also think about Hong Kong? Probably. Now that Hong Kong’s National Security Law, passed in 2020, has eviscerated the “one country, two systems” formula that provided a semblance of legal protection for Chinese entrepreneurs, they could be in for a rude awakening.

Hong Kong has been dragged away from the rule of law toward China’s “rule by law” — and this comes at a time of geopolitical tensions, deglobalization and increasing economic insularity. New safe harbors such as Singapore have emerged, but this time they are hosting economic refugees from China rather than performing the institutional functions that previously powered China’s high-tech entrepreneurship. Soon, China will feel the effects of no longer being able to outsource the rule of law and the other basic ingredients of innovation-driven growth, and it will pay a steep price for getting basic economics so egregiously wrong.

Huang Yasheng is a Professor of Global Economics and Management at MIT Sloan School of Management.

Copyright: Project Syndicate

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