Of all the industries that could be created by government fiat, venture capitalism looks like an unlikely candidate.

Based on the interaction between entrepreneurs with more vision than funds, and investors with cash and an appetite for risk, the sector does not lend itself to the strict regulations imposed by state bureaucracies.

Yet, China’s powerful National Development and Reform Commission (NDRC) appears set on creating domestic venture capital champions by offering them preferential treatment over their foreign rivals.

As reported by the Financial Times on Tuesday, the NDRC, the country’s top economic planning body, has issued rules aimed at encouraging the formation of venture capital firms run by Chinese managers, funded by Chinese investors for the benefit of Chinese companies.

The carrot for the domestic equity firms is the NDRC’s “recommendation” that local governments provide tax breaks, loans and even direct investment.

Chinese venture capital firms would also enjoy less stringent financial and regulatory requirements than their foreign counterparts.

“It’s an attempt by the government to give rise to a new industry,” said Rocky Lee, a Beijing-based senior attorney at the law firm Lovells. “They are looking to fill a gap because the government sees it as a great industry.”

The initiative – known as “Measure no.39” - has caused concern and disappointment among foreign private equity groups, which dominate China’s venture capital sector, and trade officials.

They are worried that the state initiative may skew the playing field towards domestic investors, reducing opportunities and returns for the foreign firm, which are looking to put an estimated US$5bn into Chinese companies in the next few years.

“It is not really in the spirit of the World Trade Organisation rules,” said a foreign venture capitalist yesterday. “We can only hope that the different treatment will not last too long and that the government will not go too far and try to control the whole VC industry”.

Trade officials agree that the Chinese plan appeared to flout the spirit of WTO rules by discriminating against foreign venture capital investors. However, they cautioned that it was unclear whether it violated their letter and could be challenged successfully by other countries in the organisation’s quasi-judicial disputes procedures.

“The Chinese could probably eventually get away with it,” one said.

The treatment of venture capital is a grey area in international trade law.

There is no agreement on whether it should be classified as banking, where China has made extensive commitments to open its market, or as a securities business, where Beijing has given much weaker undertakings.

Trade officials said that if the issue were to be tested, the activity would probably be categorised as a securities business, which would enable China to avoid WTO litigation.

Industry observers said the timing of the NDRC’s initiatives might reflect Beijing’s growing concerns at the large profits made by foreign venture capitalists in China.

Names such as Shanda, an online games company, Ctrip, a web-based travel agent, and Baidu, the search engine whose price rocketed on its Nasdaq debut this year, have become synonymous with large profits for foreign venture capitalists.

Others argue that Measure no.39 might be part of rising protectionist rhetoric in some quarters of China’s government, following setbacks overseas for state-owned companies, most notably China National Offshore Oil Corp.

The country’s third largest oil company, CNOOC was forced to withdraw its US$18bn hostile bid for US-based Unocal after meeting fierce opposition from the US Congress.

Some foreign venture capitalists are more relaxed, pointing out that international companies will retain advantages over their domestic rivals.

“In order to be successful in this sector, you have to have global connections, especially if the exit route is on Nasdaq,” said one yesterday. “Unless you have expertise and judgement, no tax break will be able to help you”.

Nevertheless, considering the ease and success with which China’s government embraced capitalism, foreigners would do well not to underestimate their efforts in venture capitalism.

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