Guiding Finance: China’s Strategy for Funding Advanced Manufacturing

[Chinese government] guidance funds have a mandate to focus on strategic technologies rather than simply generating returns. . . . By con­trast, funding patterns in Silicon Valley have trended toward favoring consumer-facing companies with less innovative technology but a short­er timeline to profitability.

—U.S.-China Economic and Security Review Commission¹

What is the purpose of finance and its relationship with the real economy? How can the financial sector better support innovation and national growth? What financing tools can lead to improved national competitiveness? What role should the state play, if any, in guiding capital?

These questions are not debated in the United States, at least not generally. The first question is not debated in China, either, because the answer is settled: finance should support the real economy. But China is vigorously grappling with the other points of political economy and is developing new theories and institutions—and its government is experi­menting with many new financing mechanisms—to support many different industrial policies. These new policy instruments combine state capital with market mechanisms. Such experiments offer insights into how the United States might fix its own market failures plaguing the fin­ancing of advanced hardware industries and the lack of patient capital in America.²

The largest of these new Chinese financing vehicles, as measured by assets under management (AUM), are government guidance funds, sometimes called industrial guidance funds. These are state-sponsored, public-private venture capital (VC) funds with a dual mandate of supporting industrial policy goals while providing investment returns. They aim to bring market competition to state owned enterprises (SOEs) while simultaneously channeling government funding to private firms. Their scale is enormous, with a fundraising target of up to $1.6 trillion.

Industrial guidance funds can finance start-ups, but unlike U.S. VC funds, they also provide patient capital for the scale-up of hardware technologies and capital-heavy advanced manufacturing. Economist Barry Naughton writes that the purpose of the biggest of these Chinese industrial guidance funds, the National Integrated Circuit Fund (also called the “Big Fund”), is to “help companies scale up. . . . The goal [is] to take existing companies and projects and provide them with ample funding to complete large-scale projects quickly.”³ He quotes the Ministry of Finance, which describes the fund as “an organic combination of national strategy and the market mechanism.”

Wall Street and the U.S. VC industry have mostly ignored these new funds. But anyone interested in the future of U.S.-Chinese economic competition—or maybe just the future—should not. Guidance funds involve subsidies to industry through equity investments; unlike previ­ous Chinese methods of delivering subsidies through cheap loans or outright grants, they involve some market involvement. Guidance funds also show the enormous resources China is directing toward industrial policy, and the country’s ambitions to not just catch up with, but to actually surpass, the United States in advanced technology.

China may be the workshop of the world, and the central player in global manufacturing supply chains, but it has not yet achieved com­parable successes at indigenous innovation, even if this is changing. As a still-developing country, it faces many hurdles to innovation, primarily nonfinancial.

It is actually the United States, more than China, that could benefit from the introduction of a guidance fund–type structure. The United States faces severe financial constraints when it comes to scaling domes­tic innovations in hardware technology. The U.S. VC industry, despite its immense successes in software, pharma, and biotech, largely falls flat when it comes to supporting innovation in hardware and the scale-up of manufacturing.⁴ The United States has so far been unable to deliver a new and robust financing model for providing the patient capital needed to compete against China’s ambitions in and resources directed toward advanced manufacturing, though there are several ongoing legislative efforts. Guidance funds could offer improvements over these proposals because they involve market competition and, critically, incentivize the participation of the private financial sector, amplifying any government investments.

To be sure, Chinese industrial guidance funds cannot and should not be directly replicated in their current form in the United States. Their existence is specific to the Chinese economic context and the Chinese Communist Party’s policy landscape; they are largely unintelligible outside of it. And guidance funds have a political as well as economic logic: by channeling state investment to the private sector, they provide the government with an additional window through which to monitor the financial stability of private enterprises. This monitoring has the potential to be coercive. Nevertheless, despite their various problems, certain features of guidance funds are worth a closer look as they suggest new ways to provide the patient capital required to build manufacturing capacity and strategic industries.

The Origins of Guidance Funds

A handful of Chinese government guidance funds were established around the early 2000s, but they started to become a major industrial policy financing tool around 2014.⁵ This is when the State Council published the “Guideline for the Promotion of the Development of the National Integrated Circuit Industry.”⁶ The report highlighted the use of traditional industrial policy financing tools, such as domestic devel­opment banks and commercial banks. But it also called for something new: a national integrated circuit industry investment fund—an indus­trial guidance fund making equity investments—dedicated to this sector. The fund would focus “on supporting integrated circuit manufacturing with market-oriented operation . . . [and] encourage various social ven­ture capital and equity investment funds to enter the industry.”

The immediate cause of this sudden push by China to develop its integrated circuit (IC) industry was the Edward Snowden revelations. Snowden disclosed that the NSA had breached Chinese servers and could spy on China. He also offered details about the Stuxnet attacks on Iran. This information led a group of senior Chinese tech executives to express their concern that China’s dependence on U.S. technology was a security threat. The solution, they said in a joint letter, was for China to develop its own IC industry. Other internal factors were also at play, including China’s long-held ambitions in IC and broader efforts under Xi Jinping to create a new development model, involving both market forces and state guidance, to enable the Chinese economy to catch up to the West.

This chronology—which is widely accepted by Western China-watchers⁷—is at odds with the narrative sometimes heard in America that claims China was provoked into taking more aggressive industrial policy actions by “Trump’s tariffs,” as crafted by Trade Representative Robert Lighthizer. This argument holds that, without the trade war started by the United States, the economic relationship with China would have remained collegial. In fact, China’s massive efforts to upgrade its IC industry predate the tariffs. Moreover, the episode shows that in the same way U.S. policymakers are worried about reliance upon China, China’s officials are worried about reliance upon the United States.

Structure of Industrial Guidance Funds

“A ‘guidance fund’ is not necessarily a legally defined entity, it is more of an analytical characteristic. It is a fund with strong state involvement in it, through financial as well as human resources, that invests in emerg­ing strategic industries,” says François Chimits of the Berlin think tank merics. (Merics, Europe’s leading think tank on China, was sanctioned in 2021 by the Chinese Foreign Ministry along with three other European institutions in retaliation for European sanctions on Chinese officials in Xinjiang accused of human rights abuses.)

Guidance funds are often focused on supporting a specific sector, such as advanced materials, or an activity, such as industrial upgrading.⁸ Within this descriptive framework, several patterns emerge: funds roughly follow a private equity (PE) model or a VC model (in China, the distinctions between VC and PE are blurred⁹), with a general partner who is responsible for running the fund, and limited partners who are the investors. The fund sponsor, which provides the initial funding, operates directly under the auspices of national, provincial, or local government, and the fund is administered by a related managing agency. The bulk of the capital comes from the limited partners who are called “social capital” investors, and tend to be SOEs or government banks; Western involvement has so far been minimal.

Though guidance funds are sponsored by the state, one goal is for the internal management to have a private sector background. In a quasi-acknowledgement of Lawrence Summers’s dictum that “the government is a crappy venture capitalist,” the funds try to hire professional private sector venture capitalists rather than long-term state employees to run them, even if the state is guiding the direction of their investments.

The benefit of using this private equity or VC-like structure is to bring market competition into industrial policy. The state still has the upper hand and determines the sector or activity to invest in, but the funds bring in market competition, even if it is sometimes just between different state-owned enterprises. Says Chimits, “though it is hard for many in the West to conceive, in China market liberalization in practice means more competition among state supported actors.”

Georgetown’s Center for Security and Emerging Technology (CSET), in its issue brief on guidance funds, notes, “Guidance funds allow the Chinese state to leverage market discipline and resources. Chinese policymakers began to recognize the flaws of subsidy schemes and other traditional industrial policy tools. By bringing the profit motive into industrial policy, guidance funds aim to avoid these prob­lems.”¹⁰ Funds can pursue a variety of investment techniques, including direct investments, or very frequently function as a “fund of funds” for other guidance funds.

Though the funds are profit-seeking, their universe of potential investments is tightly prescribed. Funds “shall not invest in secondary market stocks, futures, real estate, securities investment funds . . . insur­ance plans and other financial derivatives,” according to one Ministry of Finance regulation. Rather than speculating within the financial econo­my in search of returns, their core purpose is to support industrial development in the real economy.

Specifically, they can provide the patient capital required for over­coming the “valley of death” associated with scaling up manufacturing when capital needs are high but there are no revenues for years to come. Chinese government guidance makes clear that funds are intended to fill this gap. A state newspaper quoted by CSET explains the rationale for a state-backed financing instrument: private investors prefer quick returns “over nationally strategic areas that require long-term financial sup­port.”

Fund managers acknowledge this long-term objective and actually use the phrase “valley of death.” Liu Kefeng, chairman of Beijing Science and Technology Innovation Fund, in a 2019 speech at a Beijing investment conference, stated:

Under the current situation between China and the United States, what are the major powers competing for? Not only the economic aggregate, but actually more hard-core things, which is our hard technology.

Our first positioning is to be patient capital. What is the core function of patient capital? It should cover the entire process of transformation of scientific and technological achievements, and help scientific and technological innovation enterprises to cross the valley of death. This is the first investment strategy and positioning of Beijing Science and Technology Investment Fund.¹¹

Made in China 2025

Industrial guidance funds entered a period of massive growth following the 2015 announcement of “Made in China 2025” (MIC2025). This called for Chinese leadership in ten advanced industries, including electric vehicles, robotics, artificial intelligence, and medical devices. Industrial guidance funds were seen as, and remain, the primary financing tool for the implementation of MIC2025.¹²

A bloom of industrial guidance funds soon followed, reaching a total of 1,741 by early 2020,¹³ though the growth trend both in terms of new funds launched and assets raised has been slowing since 2018. The planned fundraising target for these funds is $1.6 trillion, with almost every municipality and province announcing one. The amount actually raised, however, is smaller than this, and the amount deployed smaller still. Some estimates put the total amount raised at 60 percent of the target, or just under $1 trillion, a still sizeable figure.¹⁴

“Guidance funds expansion to these additional prioritized sectors was based on the successful experiment of using them for IC. Learning, flexibility, adaptation, and scale up of successes is typical in Chinese economic policy making,” says Meg Rithmire of Harvard Business School. China’s model isn’t precisely bottom-up, but once the state sets a technological goal, say in EV charging technology, this is typically implemented via regional experimentation, followed by the scale-up of successful pilots. This approach is notably different from the top-down approach of American economic policy making. The American policy approach is much less flexible and does not typically build in such experimentation. Instead, the policy is typically hammered out among legislators and their staffs and then formally drafted without first using regional pilots to identify successes. (Of course, Chinese flexibility does not extend to political rule, where China’s authoritarian political system has been described as “frozen,” with power centralized in the hands of Xi Jinping.¹⁵)

Rithmire says the way guidance funds work in practice is that “the CCP announces a target for a guidance fund, seeds patient capital and expects LPs to match it.” Quantum computing is one example. Rithmire says, “Quantum computing is not going to happen unless the state is involved. The state sent a signal to the private sector that this is now a safe investment and they were to follow suit. Everyone in Beijing understood this.” Anecdotally, Rithmire noticed a shift among VC and private equity managers she knew in China. Whereas previously they made investments in the consumer innovation channel, such as makeup delivery services or bike-rental apps, they reoriented their investments to sectors prioritized by MIC2025.

The use of guidance funds also marked a major change in the way the government supports industry.¹⁶ In the past, Chinese government subsi­dies for heavy industry have traditionally been through “below-market debt,” in the form of cheap loans from state-owned banks, or outright grants. The Chinese aluminum industry, for example, is rife with subsi­dies throughout the aluminum value chain, including subsidized elec­tricity from coal-fired plants and loans from state-owned banks to state-owned aluminum companies. China has no natural advantages when it comes to aluminum smelting, like the hydropower resources found in Iceland or Siberia. Nonetheless, it now dominates this industry, ac­counting for close to 60 percent of world output.

Guidance funds, in contrast to these earlier forms of subsidy, use equity financing. Here outright subsidies are hard to identify.¹⁷ Some in the West feel guidance funds are simply a way to skirt WTO agreements concerning subsidies. This was the view of the White House’s supply chain report, which argued, “it is clear that China’s government de­signed its ‘venture capital’ model to facilitate a massive subsidy cam­paign to develop its domestic semiconductor capability to avoid any WTO oversight.”¹⁸ But given the size of China’s domestic market and continued experimentation with its development model, not everything China does is centered on Western institutions.

This doesn’t mean subsidies aren’t involved, which the OECD has attempted to quantify. To use the OECD’s definition, if the government tolerates lower returns on equity than private investors, the investment is deemed “below-market equity.” It undertook a study measuring the potential distortions introduced by “below-market finance” (both debt and equity) in the semiconductor value chain across many countries. The OECD found:

Government support provided through the equity channel (“be­low-market equity”) overwhelmingly benefitted Chinese firms in the sample. The large investments that Chinese government funds have made in domestic semiconductor firms profoundly reshaped China’s semiconductor industry. There notably appears to be a direct connection between equity injections by China’s government funds and the construction of new semiconductor fabs in the country.¹⁹

Evaluating the Impact of Guidance Funds

Are guidance funds actually successful at achieving their goals? There is an inherent tension in guidance funds’ “double bottom line” (a phrase used in ESG investing to refer to performance and sustainability goals), here referring to their performance and strategic objectives. The expect­ed returns as well as performance history of guidance funds are unclear. Naughton has found that the “‘Big Fund’ targets a 5% return but to accomplish this, it had to split itself into two, a strategic sub fund targeting no returns and a ‘commercial sub fund.’”²⁰

Funds do need to offer positive returns to their investors, even if these investors are SOEs or state banks. Fund managers themselves are financially incentivized to increase AUM and to outperform, but also to stay within their prescribed industrial policy guidelines. Industrial guid­ance funds are designed to be a low-risk investment. This is achieved by the government providing different types of guarantees. The government sponsor might absorb first losses, forgo interest payments, or agree to buy limited partners’ shares at an agreed upon price.²¹

The main criticism of guidance funds by Western-based China watchers (Wall Street analysts tend not to cover them) is that they are highly inefficient and misallocate resources. This same accusation could be leveled against earlier Chinese subsidization programs, however, such as for high-speed rail, or for Huawei. The Wall Street Journal reported, “Huawei had access to as much as US$75 billion in state support over the past 25 years, including grants ($1.6 billion), credit facilities ($46.3 billion), tax breaks ($25 billion), and subsidized land purchases ($2 billion).”²² These programs, which also involved mercantilist practices, were not put in place for reasons of economic efficiency. Instead, the goal was to grow priority sectors. This objective was achieved, with China gaining strategic leadership of both industries. Industrial guid­ance funds aren’t efficient, but that doesn’t mean they can’t be effective.

Personal protective equipment (PPE) during the pandemic offers another, more recent example. During the early days of the pandemic, Chinese produc­ers were accused of flooding the U.S. market with low-cost surgical masks. Remaining U.S. producers were driven out of the market. Though it is a widespread belief that low labor costs account for Chinese competitiveness, these masks were sold at prices below the cost of raw materials. As usual, the specific subsidies involved are opaque and may involve guidance funds as well as other financing sources. But the results are clear: this subsidy-centered model has proven to be globally effective. If in 2019, the first year of the pandemic, 21 per­cent of global PPE exports came from China, by 2020, 43 percent of global PPE exports came from China. Almost none of these were donated, with 99 percent of exports taking the form of sales.²³

Still, Western analysts have identified several flaws specific to guid­ance funds. First, there are too many funds. Funds duplicate efforts, leading to overcapacity in a few favored sectors. Local funds may end up subsidizing nonstrategic local industries, and there can be tension between provincial development and national development objectives. There is ample evidence of corruption, but little evidence of market discipline.

Ngor Luong, an author of the CSET study of guidance funds, says, “often times, they don’t raise as much as intended, and they don’t invest the way they are supposed to because their SEO investors have no appetite for risk. Instead of hiring professional managers, they routinely recruit local officials. Guidance funds may actually crowd out other types of investments.” She adds, however, that “there are also a handful of funds that are successful in raising capital and investing in projects.”

The experience of the National IC Fund, or the Big Fund, exemplifies some of these vulnerabilities and reveals the broader challenges China faces in developing advanced technology. China runs a large trade deficit in semiconductors and is well behind the technological frontier in areas such as electronic design automation, software, and fabrication capital equipment. Even its most advanced foundry is generations behind industry leader TSMC. Douglas B. Fuller of the City University of Hong Kong provides an explanation of China’s continuing inability to generate true technological transformation in IC despite the vast resources thrown at the industry. He says, “essentially, guidance funds ‘misallocate’ resources by throwing re­sources to non-efficient state owned firms.”

In his book, Paper Tigers, Hidden Dragons: Firms and the Political Economy of China’s Technological Development, Fuller groups China’s IC industry into three types of firms: SOEs, foreign multinationals with production facilities in China, and what he terms “hybrid” firms, which are private firms run by ethnically Chinese foreign investors.²⁴ There are critical differences in the capabilities of each category of firm, which is at the core of the capital misallocation by guidance funds.

According to Fuller, SOEs have had very limited success in adopting new technologies or tapping new markets. These firms continue to coast along on guaranteed state procurements, while their managers “avoid risky activities—including technological experimentation—that could expose them to future accusations of losing or destroying state assets.” Nonetheless, “policy initiatives continue to lavish resources on sluggish state owned firms.”

Nor are foreign multinational corporations operating in China a source of true technological innovation in the IC industry. They are extremely guarded about placing cutting edge production facilities in China.

On the other hand, Fuller argues that China does demonstrate technological and commercial prowess in the third category of firms, hybrid émigré-run firms, which have been the true drivers of technological development. But these are not the firms supported by the National IC Fund, except when they are occasionally taken over. For example, SMIC, a leading hybrid-run semiconductor foundry, was taken over by the National IC Fund in 2015. Fuller writes, “the firm’s take-over by the state casts doubt on its competitive sustainability.” He adds, “China does not lack for industrial investment, it has too much industrial investment and inefficient allocations.”

Yet China’s efforts in the IC industry are not the whole story of guidance funds. There are other sectors, often supported by guidance funds, where the distance to the technological frontier is much smaller. These sectors have fewer domestic incumbents to hold back progress, or Western incumbents to catch up to. In new energy vehicles (NEVs), batteries, and quantum technologies, China might now hold the edge.

“All the non-SOE sectors of high industrial priority are basically flooded with state-guided capital,” says merics’s Chimits, including quantum computing and artificial intelligence. There is very limited information on guidance funds’ actual activities, but there have been some clear breakout successes.

For instance, Hefei’s local government, in 2020, made an investment through a guidance fund in NIO, China’s leading rival to Tesla. NIO was struggling in 2020. Not anymore. Hefei made a return of 5.5 times its initial investment. “From our investment in Nio, we ruthlessly made money,” said Yu Aihua, the top Communist official in the city, the South China Morning Post reported.²⁵

Hefei is emblematic of the changing models of Chinese local govern­ment support for industry. Historically, Hefei offered tax breaks or loans to private companies, later followed by a direct investment approach. More recently, it has pursued an indirect investment approach using guidance funds run by professional managers.

Hefei’s successes with NIO have fostered an entire EV ecosystem centered in the city. Volkswagen has made Hefei one of its main production hubs for EV components including batteries. The case study of NIO shows that guidance funds can deliver VC-style financial returns coupled with state economic growth objectives.

Guidance Funds in China’s Economic Campaigns

MIC2025 has been followed by more ambitious policies, including, most recently, the “common prosperity” program. So far, the most visible initiative of this program has been a crackdown on the real estate and consumer tech sectors, but it is not yet clear what “common prosperity” will involve. Nis Grünberg, lead analyst at merics, says, “it is not yet much spelled out about both the specific mechanisms intended for achieving common prosperity, and more fundamentally, what ‘common prosperity’ actually means in terms of concrete targets.”

Part of the confusion surrounding China’s grand economic programs is that they are actually “campaigns,” the CCP’s traditional mobilization and propaganda method. “Campaigns and their mechanisms for imple­mentation are rarely fully defined,” Rithmire says. “But when there is a campaign, everyone knows what to do and to jump on the bandwagon. Both political and social actors have gone through campaigns.”

The Great Leap, the Hundred Flowers, the One Child Policy, and Belt and Road were all campaigns. And though it isn’t widely recognized in the West, so are guidance funds. “Guidance funds are a campaign. With campaigns, there is no central office,” Rithmire says. “There is no central list of commands or person.” The amorphous, decentralized, shape-shifting quality of campaigns explains why Western analysts have had such a hard time understanding Belt and Road. China’s model is not just a bigger version of the East Asian development states of Japan and the latter’s onetime colonies of Korea or Taiwan. Though it may borrow from each, it is also rooted in CCP tradition.

Campaigns follow a familiar trajectory of ramp-up and exuberance, followed by a period of ramp-down and reevaluation, according to Rith­mire. Guidance funds are now in the latter stages of this tra­jectory.

The CCP’s own theory organization recently offered further insights into what the future may hold in a document titled, “Give full play to the role of policy finance in supporting common prosperity,” written by researchers from the Beijing Research Center for Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era.²⁶ “The phrase ‘policy finance’ and document [as a whole] describe the landscape in China where different finance vehicles in addition to guidance funds are developing,” Grünberg says. “Policy finance is a broader concept than guidance funds but includes them.”

Market mechanisms still play a role in policy finance, unlike tradi­tional subsidy approaches. The Beijing Research Center theorists write:

Grasp the relationship between policy finance and market-oriented operation. Policy financial institutions are still essentially statutory financial institutions with operational risks, rather than government departments, and they must also adhere to the principles of maintaining capital and making small profits in the process of resource allocation. Therefore, policy financial institu­tions should not use the “blood transfusion” model . . . in the process of helping enterprises . . . but should “create their own blood” to form a long-term financial mechanism to support common prosperity.²⁷

The medical metaphor here, according to Grünberg, is a warning against life support from public coffers (“blood transfusions”). Instead, the document calls for policy finance institutions to leverage financial markets to generate their own capital, or “create their own blood,” in the document’s language.

The Anaconda in the Chandelier

Government guidance funds don’t just fund SOEs, they provide state capital to private sector firms, too, which has not been standard practice in Chinese industrial strategy.²⁸ This funding more closely aligns private firms with the state’s economic and strategic priorities.

Guidance fund investment in a private enterprise blurs the distinction between the state sector and the private sector. The autonomy of private firms is diminished and state control increases, and with it can come increased monitoring by the authoritarian government, whether check­ing for signs of financial instability or for compliance with political direc­tives.²⁹ Indeed, the private/state binary may no longer make sense as a way to describe the operations of these funds and the companies they invest in.

Guidance funds are merely one type of mechanism for imposing more state control over private firms. Others include direct investment in publicly listed equities through “state-owned capital operation com­panies,” and the growing influence of party cells within private compa­nies.

The CCP usually doesn’t have to explicitly disci­pline the private sector; the threat alone is often sufficient. In the memorable metaphor of China scholar Perry Link, the Chinese government and its ability to exercise control resembles “a giant anaconda coiled in an overhead chandelier. Normally the great snake doesn’t move. It doesn’t have to. It feels no need to be clear about its prohibitions. Its constant silent message is ‘You yourself decide,’ after which, more often than not, everyone in its shadow makes adjustments.”³⁰

Where is all this going? Will guidance funds be used primarily for political purposes, to rein in the private sector in order to subject it to greater state oversight and direction? Will guidance funds just result in misallocated resources?

Or will they succeed in their stated purpose? Will they bring market discipline to China’s development strategy, allowing the country to not just catch up with but to surpass the West in advanced technology? Even if there is a lot of waste, China is throwing vast resources at this ambition. And through the unique financial innovation of guidance funds, which provide both seed and patient capital, it is certainly pos­sible that the next technological revolution will take place not in the United States but in China.

No one knows the answers to these questions; to echo Zhou Enlai’s assessment of the French Revolution, it is too early to tell.³¹ And part of the answer will depend on how the West responds.

Shortcomings of the Western Approach

The best results occur at companies that require minimal assets to conduct high-margin businesses and offer goods or services that will ex­pand their sales volume with only minor needs for additional capital.

—Warren Buffett, 2020 letter to Berkshire Hathaway shareholders³²

The predominant Western response to Chinese guidance funds is to look at their impact through a trade policy lens: what is the true extent of the subsidies involved and the damage to Western industry or benefit to consumers? Standard policy recommendations include forcing China to comply with its WTO commitments, improving the trade rules of the WTO related to below-market financing, or creating an alternative to the WTO altogether. The first response assumes that China can be changed, and the others that Western actors want the WTO to change, which is not necessarily true, given that Wall Street and multinational corporations have benefited from current arrangements. The profound ideological hostility to tariffs and unwavering commitment to free trade by mainstream Western economists further hinders material changes to trade policy. As Janet Yellen said, exemplifying this thinking, “tariffs are taxes on consumers.”

A less common response is to look at guidance funds from an industrial policy lens—what lessons do they hold and which of their features could be applied outside China? After all, guidance funds are state-supported financing instruments, not trade instruments. They show the scale of resources, including government resources, that will be required for the United States to successfully compete with China in advanced technology industries. Tariffs are unlikely to work if the United States doesn’t have a domestic industry left to protect or any plans to create one. Guidance funds point to the need for new and better financing solutions, and new institutions, in the United States.

The U.S. VC system is “impatient,” privileging industries like software with high intellectual property rents and low-cost scalability, and the stock market also favors capital-light companies. Neither fi­nancing method is well suited to providing the resources required by capital-heavy advanced technology or manufacturing industries, one reason those industries have declined dramatically in the United States over the last few decades. Nor is the existing bank lending system up to the task. It produces its own misallocations because of its reliance on collateral—which often does not exist for emerging industries.³³ The frontiers of U.S. financial innovation, such as fintech and payments processing, aren’t funding heavy industry or technological advances in hardware, either, despite the futuristic and triumphalist narratives these industries use in their marketing.

The American strategy seems to be to fund universities or the Na­tional Institutes of Health and then hope for the best. Americans have no qualms about government funding for basic research, but there is greater ideological opposition to state support for a particular industry or tech­nology, and industrial policy in general. For instance, commercial ship­building, a highly capital-intensive industry, is an international game of competitive subsidization.³⁴ Under the Reagan administration, the Uni­ted States ceased subsidizing this industry. As a result, although America was once a market leader, it now accounts for just 0.35 percent of global commercial ship construction. It is out of the game. This is a problem because the United States still builds naval ships but cannot benefit from cross-fertilization with commercial shipbuilding.

The United States does offer loans, grants, and other subsidies to businesses, but such policies tend to be scattershot and erratic. They are often very small. For instance, there has been one legislative proposal to provide patient capital through the Small Business Investment Company (SBIC) program.³⁵ The total: $10 billion dollars—a gesture. But this and other recent legislative proposals suggest that policymakers are finally becoming more open to industrial policy. Another proposal would create an Industrial Finance Corporation to invest in manufacturing.³⁶ There are equally promising discussions about using the U.S. Export-Import Bank for domestic lending for manufacturing.³⁷ The U.S. Senate and House have now each passed acts that would provide grants to the U.S. semiconductor industry.³⁸

The challenges facing the U.S. semiconductor industry demonstrate how competitive subsidization works in practice, and where the United States falls short. Building a new fab in the United States costs substantially more than in China. But 40 to 70 percent of the cost differential is explained by Chinese subsidies, according to analysis cited by the White House.³⁹ The same analysis found that the United States was actually competitive in taxation, but not in providing grants or direct cash for building new fabs.

In contrast to China, where there is almost too much money sloshing around to build semiconductor fabs, in the United States there is too little, notes Jimmy Goodrich, vice president of global policy at the Semi­conductor Industry Association (SIA). “We lack competitive, financial incentives to encourage onshore production. There has never been a fab built anywhere globally in the modern era without government sup­port.”

Goodrich adds, “when you look beyond the U.S., every other key player is subsidized.” He points out that without subsidies, the United States will become less and less competitive in semiconductor manufacturing, more vulnerable in its supply chain, and see a decline in its industrial base.

The chips Act (and successor legislation) could rebuild domestic semiconductor manufacturing. There are, however, many other ad­vanced technology industries besides semiconductors that will require government financial support to be able to succeed. Given that these industries are nascent or might not even exist, they have no legislative clout to build this support, unlike the semiconductor industry.

Generally, the U.S. approach to subsidies is still at the “blood transfusion” stage—keeping the patient alive—to use the Chinese theory document’s metaphor. Or, as in the case of the shipbuilding industry, the U.S. preference has been to let the patient die. The country needs a newer and broader approach to subsidies that integrates private capital and market discipline. To continue with the Chinese metaphor, such a strategy would allow industries requiring subsidies to “create their own blood.”

The Inadequacy of Grant Funding

The credit machine is so designed as to serve the improvement of the productive apparatus and to punish any other use. However, this turn of phrase must not be interpreted to mean that that design cannot be altered. Of course, it can . . . the existing machine can be made to work in any one of many different ways.”

—Joseph Schumpeter⁴⁰

To address the above shortcomings, the United States needs updated or new investment structures and financial institutions. A solution could be an adaptation or extension of the current VC/PE system, one that is incentivized to fund hardware and advanced manufacturing, namely an American guidance fund system. These funds would be structured as public-private partnerships between the government and VC-like inter­mediaries.

Identifying priority sectors for funding, as well as who is empowered to make this policy-finance decision, may appear to be a contentious, politically unsolvable issue. But there is a pragmatic way forward. Cer­tain federal agencies already fund basic research, and in the case of the Department of Commerce, have a mission to “create the conditions for economic growth and opportunity.” They are aware of specific market failures when it comes to scaling up or commercializing new technologies. Such agencies are natural “verticals” along which to organize policy finance objectives. So too are state governments interested in regional development that are willing to pursue a “double bottom line” (of in­vestment returns and local growth).

In this proposed model, the agencies or state governments would set the policy objectives for funds. They would de-risk investing by provid­ing seed capital, below-market-interest-rate loans, and guarantees. This would incentivize investors to participate, who would provide most of the capital. Tax advantages might be required too. Actual management of the fund would be in the hands of an intermediary which can sort through various investment opportunities and provide investment dis­cipline. Market involvement and the profit motive is key: these provide the ultimate discipline against the fund favoring politically connected, nepotistic companies. Failure is very much an option.

The rationale for establishing such a funding mechanism is that capital markets on their own aren’t willing to provide the capital required to scale up hardware technologies, while government on its own cannot plausibly do so either. A properly structured Ameri­can guidance fund would amplify any initial government investment with private sector participation while simultaneously providing market discipline, allowing the market to pick winners.

This preliminary sketch shows some of the characteristics of a U.S. guidance fund–type entity: government providing de-risking and seed capital, an intermediary running things, and market competition. A likely buyer for the technology the fund is investing in would be helpful too, with the government again filling this role. The various inputs—loans, tax relief, advanced market commitments from the government—need to be titrated to make sure the fund reaches its objectives and all participants share in both risks and returns. America’s legions of finan­cial engineers are there to make this happen.

Yet there are deeper issues and uncertainties surrounding the optimal design of new financing structures that go beyond just financial engi­neering. These lie in the realm of policy.

Different types of subsidies have different impacts on the real economy. This is an arcane but important area of research. Subsidies come in many shapes and sizes and are not perfect substitutes for one another. The OECD has done preliminary research in this area, which should inform current policy proposals for financing manufacturing, as well as the design of future policies. For instance, it is possible that grants, as used in the chips Act, might not be optimal if the goal is to build domestic manufacturing, though they might be ideal for funding R&D. Instead, “below-market borrowings” (state loans offered at pref­erential rates or with guarantees) are more closely associated with investment in manufacturing capacity. (Below-market equity as found in guidance funds—equity infusions with below-market expected re­turns—was not analyzed.)

Specifically, according to the OECD (which scrupulously notes that correlation is not causation), government grants are not associated with net investment in fixed tangible assets, unlike below-market borrowings:

Government grants do not appear in general to be as correlated to investment as below-market borrowings, irrespective of the speci­fication used. In most cases, the correlation between grants and investment is small and not statistically different from zero. This supports the presumption that below-market borrowings affect investment more directly than other forms of support that do not target companies’ cost of capital. A lower cost of capital should in turn incite firms to invest more than they would otherwise, all other things being equal.⁴¹

These findings need to be replicated and incorporated into any proposed new American guidance fund structure. This new approach also needs to be compared to models like the Ex-Im Bank, the Finance Corporation, the chips Act, or the Infrastructure Law that will fund battery-related projects. Which model involves the greatest market com­petition? Which is most open to nonincumbents who are not Washington insiders? Which model requires the least government resources and provides the most leverage—that is, offers the most bang for the buck?

The Chinese government, which has had years of experience with traditional approaches to subsidization, has moved on to this more market-conforming model for a reason. American policymakers will have to find their own answers. But it is very likely that such a model will mark an improvement over the grants-based model increasingly favored in the United States, which rewards companies that are good at writing grants rather than those with a better technology.

Case Study: mRNA Vaccine Technology

Operation Warp Speed (OWS) was successful in producing and distributing huge volumes of an effective Covid vaccine under a dra­matically accelerated timeline. But the longer history of the foundational mRNA technology also reveals the failures of the U.S. model for fi­nancing the development, scale-up, and production of breakthrough technologies. The underlying mRNA technology, in fact, long predates Warp Speed—one reason it was possible to produce vaccines so quickly in 2020. And despite significant government efforts to foster the tech­nology, it was languishing in the private sector before OWS enabled its rapid scale-up and implementation. The more complicated saga of mRNA technology thus invites consideration of an alternative history, in which guidance funds might have been used to support the proliferation of mRNA vaccines long before—and without requiring the heroics of—Warp Speed.

The theoretical possibility of mRNA vaccines was discovered as early as 1950. In 2005, scientists at the University of Pennsylvania discovered a way of altering mRNA to increase its therapeutic potential. Their research breakthroughs, and parallel work on using lipid nanoparticles as a delivery mechanism, created the foundation for today’s mRNA vaccine technology.

The federal government became directly involved in the following years, as darpa (the Defense Advanced Research Projects Agency) began funding mRNA vaccine work in 2010. In 2013, darpa awarded a $25 million grant to Moderna, then a new biotech start-up, which would eventually develop a successful Covid vaccine and achieve massive commercial success.

Yet prior to Covid, and OWS, mRNA vaccine technology failed to gain traction in the pharma industry, despite government grants, and despite success in raising private sector VC funding. As Dr. Dan Wat­tendorf, who founded a program within darpa to pursue mRNA efforts and later became a director at the Gates Foundation, explained, “Darpa’s early investments de-risked the technical problem. But they didn’t solve the fundamental capital shift we needed.”⁴²

While mRNA appeared technologically promising, traditional phar­maceutical companies were not interested in making the large investments needed to develop and obtain regulatory approval for a new manufacturing process—one that would only disrupt their legacy vac­cine busi­nesses. And while start-ups and their VC backers might be eager to develop new technologies, they are not well suited to building capital-intensive manufacturing and distribution networks. Vaccines in general are not a particularly exciting subsector of commercial pharma. The U.S. vaccine industry is highly concentrated, with a handful of pro­ducers, and preventing infectious disease is generally not a good business model: vaccines do not require daily usage. For all these reasons, the widespread adoption of mRNA vaccines to fight Covid required the interventions of Operation Warp Speed.

But what if, instead of grants alone, the U.S. government had sup­ported mRNA technology through the formation of an mRNA “guid­ance fund” in the 2010s? Such a fund, using both public and private sector capital, could certainly have invested in mRNA start-ups like Moderna and BioNtech. Indeed, it might have seeded a much larger ecosystem of such companies. Even more importantly, in this case, a guidance fund might have made investments in critical functions adja­cent to mRNA pharma development—but which do not offer the “uni­corn”-like return potential of biotech IP start-ups—like contract manu­facturers capable of mass producing mRNA vaccines, or the specialty logistics systems they require (e.g., ultracold storage). An expanded ecosystem of this kind might have been more successful at pressuring private sector pharma incumbents to embrace the new technology—or face competition at scale. It might also have created a constituency in Washington to encourage government agencies outside of darpa—not least regulatory agencies—to take a greater interest in promising tech­nologies before a crisis hit.

This alternative history is entirely speculation, of course. Yet it is clear at this point that government grants alone are insufficient. They may be critical to the development of new technologies, but they are often not enough to motivate the private sector to develop new indus­tries around breakthrough technologies, the effective commercialization needed to realize these technologies’ economic, national security, and other benefits.

Today, across a variety of promising technologies—from batteries, to minerals processing, to robotics, to generic pharmaceuticals—the policy debate is often framed as a choice between grants or other forms of pure subsidy, or no support whatsoever. A new policy tool that can leverage the private sector in providing “below-market finance” is sorely needed.

Government Financial Support for Industry:
An American Tradition

Some Americans see government financial support to grow priority industrial sectors as un-American, a violation of the pioneering spirit or free market principles. There is also the recent Solyndra fiasco to con­sider. (Solyndra, the thin-film solar panel manufacturer which re­ceived federal loan guarantees, went bankrupt. It was undercut by even more heavily subsidized Chinese competitors that were producing a much less advanced technology. Maybe the lesson here is the need for infant industry protection policies to accompany any loan guarantees.)⁴³ Less commonly discussed than Solyndra’s failure is Tesla’s success using government loans: in 2010, Tesla similarly received a DOE-issued $456 million loan. The loan, which helped Tesla at a critical time, allowed the company to build a production facility in California. The loan was repaid early.

These two recent examples might appear to be outliers from Ameri­can tradition. In fact, however, government contracts, loans, guarantees, and other subsidies built much of American industry. Take railroads: the historian Richard White, in his book Railroaded, writes, “The transcontinental railroads emerged in markets shaped by large public subsidies and particular legal privileges.”⁴⁴ The transcontinental lines were con­structed in advance of market demand, and the government essentially created new markets. U.S. states had previously subsidized the building of canals. With the transcontinental railroads, the subsidies now came from the federal government.

The Pacific Railway Acts of 1862 and 1864 provided loans and outright donations to railroads to build transcontinental lines, with levels of largesse almost similar to today’s Chinese subsidization. Con­gress lent railroads $50 million in government bonds, with the federal government guaranteeing the princi­pal and the interest. Congress also donated land to the railroads (while the federal gov­ernment kept an equal amount of surrounding land). Both benefited as the land rose in value when the railroad came in. The size of the land grants is staggering. White notes that the Union Pacific received land grants equivalent to the area of New Jersey plus New Hampshire; the Central Pacific received the equivalent of Maryland. Incidentally, the same financing mechanism for development—public land sales—was used in the Land-Grant Col­lege Act of 1862 (the Morrill Act). MIT is a land-grant institution.⁴⁵

The building of the railroads was also marked by questionable corpo­rate practices that hardly seem foreign today: extensive lobbying, mono­polization, and “financialization”—here meaning dividend payments not based on actual performance made in order to buoy stock prices and pay owners. The entire industry was marked by “misallocations,” to use contemporary language, including remarkably poor technology. But despite these inefficiencies, the subsidies were effective: the transcontinental railroads were successfully completed. White concludes:

In 19th century western North America, railroads and the modern state were co-productions. The litany of the work they did to­gether is impressive. The governments of North America lavishly subsidized the corporations, and the corporations assisted in the great state projects of bringing half a continent under the domination of central governments.⁴⁶

The most recent great state project—Operation Warp Speed—was similarly a coproduction with industry. It, too, involved government financing, though Warp Speed’s industrial policy interventions went well beyond finance and included building new factories, organizing clinical trials, mapping supply chains, logistics, and the distribution of vaccines. Warp Speed structured public-private partnerships in a much better way than most contemporary efforts, using a type of cost-sharing contracting known as “other transaction authority.” Warp Speed also offered “advanced market commitments,” that is, purchase contracts, to Pfizer if its vaccine received FDA authorization. This incentivized the production of vaccines by removing financial risks. Comparing Warp Speed and its mRNA vaccines to the inferior vaccines developed by China shows that China’s technological supremacy is not inevitable nor is China an unstoppable economic force.

The Visible Hand (and the Wealth of Nations)

China’s rise has nevertheless presented a shock to the U.S. economy, and it is an intellectual shock, too. Rather than relying on the invisible hand, China uses a very visible hand. And in doing so, not only has the party-state reshaped the Chinese economy, it has reshaped American markets, a fact that many Americans, particularly market fundamentalists, have trouble digesting. Proclaiming the superiority of “markets” is not an adequate response when Chinese industrial policies shape the market.

At the very least, China’s rise should cause a scramble, or updating, of America’s institutions and policies, to better understand this new economic model and to craft a more effective response. This is especially true at the federal level, where many agencies were designed to fight the Cold War, World War II, or the Great Depression, but not the economic impact of China’s development model.

The rise of China means a rethinking of academic disciplines, as well. Economics is not well suited to lead such a task, given that it is intensely ideological rather than pragmatic, and its methodology privileges simpli­fying abstractions over the complexities of actual firms and institutions. There is also its poor track record to consider, such as its failures to predict the great financial crisis, or leading Harvard economists’ catastrophic privatization advice to the former Soviet Union.⁴⁷ A whole new analytical approach is required, and universities might be the wrong place to pursue it.⁴⁸

The focus, moreover, should not be primarily on lessons from China, but rather on lessons from America’s past, and the country’s earlier periods of economic dynamism. During these periods, the federal gov­ernment, corporations, and the financial sector aligned to support the real economy, unlike today.

America’s current economic policy repertoire is exceedingly limited. There is a need for a broad new set of policies in the United States centered on guiding finance to productive sectors. Credit guidance policies utilize many tools—subsidies are merely one—but the general idea is to steer resources to sectors capable of producing innovation and high-wage jobs. Since the financial liberalization in the 1980s, the oppo­site has occurred. Credit in the United States has increasingly flowed to finance consumption, real estate, or the financial sector itself rather than to support nonfinancial businesses.⁴⁹ The conventional narrative from each party about how to grow the economy rarely involves using guided finance to support strategically important industries with high wage potential. (Some exceptions are bipartisan support for the semiconductor industry and Democrat support for green technology.)

Similarly, discussions around innovation policy, reshoring, and re­gional economic development typically center on education, tax credits, clusters, R&D, digital connectivity, better data, scorecards, greater transparency, improved governance, infrastructure, inclusive growth, streamlined regulation, engagement with stakeholders, breaking down silos, etc. The list is endless. But less commonly discussed (and budgeted for) are the necessary financial resources, including government financial support, at the scale required to grow capital-intensive new sectors. More work is also required to understand the distinctive effects of different types of subsidies, for example grants versus below-market debt or equity financing.

U.S. policymakers seem out of ideas: the governor of New York State, Kathy Hochul, plans to bring new jobs to New York City and to raise revenue by opening more casinos. This has the “potential to gener­ate thousands of new union jobs,” according to a casino executive. Meanwhile, Shanghai recently published its plan to guide development of the space industry. Implementation will include “the construction of satellite constellations. Digital and intelligent manufacturing capabilities, reusable rockets, spacecraft research and development platforms, intelli­gent satellite software, ground terminals, applications and commercial satellite production and rocket assembly lines are other priorities.”⁵⁰

America’s institutions—its government, universities, media, and financial system—seem stuck on warmed-over policy tools from the 1980s and ’90s. What may be even more damaging than the loss of strategic industries and technologies is this failure of imagination.

This article originally appeared in American Affairs Volume VI, Number 2 (Summer 2022): 17–40.

Notes