The Hidden Tradeoff in Public Venture Capital: Lessons from China’s GVC Boom

In recent years, governments around the world have poured billions into venture capital programs to spark innovation and entrepreneurship. China’s government venture capital (GVC) funds, once hailed as a masterstroke of state-backed innovation policy, are often viewed as a global exemplar. But my research suggests the story is more complicated.

Using a manually collected 20-year dataset covering 280 Chinese cities, I examine the effects of GVC programs on entrepreneurship, as proxied by new firm formation. While GVCs boost early-stage venture investment, they appear to discourage overall entrepreneurial activity. The underlying mechanism is a by-industry crowd-out effect: capital floods into government-prioritized sectors, leaving other sectors sidelined and chilling overall startup activity.

This finding is both surprising and consequential. It suggests that GVCs may be reshaping market behavior in unintended ways—crowding out entrepreneurs in non-favored sectors and creating a more concentrated, less dynamic startup ecosystem.

A Tale of Two Trends

The backdrop is striking: China has emerged as a global venture capital powerhouse. In 2001, the United States accounted for 88% of global VC investment, with the rest of the world sharing the remaining 12%. By 2019, China had surged to capture 38% of global VC dollars—just behind the U.S. share of 42% (Lerner et al., 2024). This shift coincided with a massive expansion of state-backed capital: by 2022, China’s GVCs had committed over $400 billion—about two-thirds the size of the U.S. VC market.

Most Chinese GVCs are created and operated by city-level governments. These programs are typically structured as fund-of-funds that require private sector co-investment while tightly channeling capital into government-prioritized industries. This blending of public and private capital creates analytical challenges. Prior firm-level studies have struggled to distinguish GVCs from private VCs due to opaque ownership structures.

I address this by asking a simple but fundamental question: has a given city committed public sector capital to venture investment, or not? This clean treatment definition shifts the unit of analysis from individual funds or portfolio companies to the city level, enabling a comparison between cities with and without GVCs and facilitating the assessment of broader policy effects.

A city-level lens is especially useful. Even if GVCs improve firm-level portfolio performance, they may do so by picking a few winners while reducing overall entrepreneurship through capital concentration in a narrow set of favored industries. This pattern may crowd out other sectors and deter entry by entrepreneurs who anticipate limited funding opportunities.

I use a difference-in-differences design and a weighted stacked event study to address pre-trends, selection bias, timing heterogeneity, and imbalanced treated-to-control ratios. The results show that once a city adopts a GVC program, early-stage VC activity rises significantly, consistent with the policy’s intended goals.

But that is only half the story. New firm formation falls significantly after GVC adoption. This decline is not explained by economic conditions, demographics, or other confounding policies, all of which are controlled in the analysis. Nor is it a fluke—the result holds across multiple robustness checks, including propensity score matching, placebo tests and alternative measurements for entrepreneurship.

Sectoral Targeting and Capital Reallocation

Digging deeper, I find that GVCs operate under strict mandates to invest only in government-supported sectors—such as semiconductors, new energy, and advanced materials—and within the sponsoring city’s jurisdiction. Many GVC programs also include regulatory carve-outs: fund managers enjoy explicit liability exemptions when investing in these “safe” sectors, but face heightened legal exposure when backing unapproved ventures.

These legal structures matter. Based on 22 interviews with VC practitioners, financial advisers, and lawyers, I found a consistent theme: private VCs adjust their investment strategies to align with GVC priorities. They do so to access follow-on capital, streamline regulatory approvals, and ease IPO exits, which is especially important in China’s policy-sensitive capital markets.

To test this mechanism, I conduct a triple-differences analysis comparing supported and unsupported industry sectors. The results are striking: GVCs significantly increase new firm formation in policy-supported sectors but depress it in non-supported ones. Entrepreneurs, seeing capital flowing toward a narrow band of industries, appear to exit the market or pivot toward politically favored areas.

Innovation or Illusion?

One might ask: even if entrepreneurship declines overall, could the rise in early-stage investment and targeted support for key sectors still be considered a net positive?

That depends on the quality of innovation. Using patent data as a proxy, I find that GVC programs lead to a decline in invention patents, which require substantive review and are generally seen as higher-quality innovation. In contrast, there is an increase in design patents, which do not require such review and are often labeled “junk patents” in both academic and practical contexts. This pattern suggests that local governments may prioritize easily inflated metrics over meaningful innovation, reflecting broader concerns about bureaucratic incentives and symbolic compliance.

Lessons for Policymakers

China is not alone. Countries from Israel and India to Germany and Singapore have embraced government-backed VC models. But China offers a cautionary tale: GVCs can be powerful policy tools, yet their impact depends on careful design and implementation. Poorly structured programs may not fail overtly, but can subtly distort market incentives and suppress the very innovation they aim to promote.

As public capital becomes more active in areas such as sustainable technology and clean energy, understanding these dynamics is critical. GVCs can play a valuable role in fostering innovation. Their success, however, depends on sound governance, well-aligned incentives, and vigilance against unintended consequences.

____________

Isabelle Zhang is a S.J.D. Candidate at University of Virginia School of Law

The ECGI does not, consistent with its constitutional purpose, have a view or opinion. If you wish to respond to this article, you can submit a blog article or 'letter to the editor' by clicking here.