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The Gulf’s economic vision aims to create vibrant private sectors free from dependence on hydrocarbon revenues. However, during the transition period, some governments are acting as leading venture capitalists in strategically important sectors such as renewable energy and civil aviation.

China’s experience suggests that this increasingly popular model of state capitalism has flaws that policymakers should be aware of as they restructure their economies.

When an entrepreneur starts a new company, no matter how brilliant the idea, at some point he will need external investment in order for his company to grow and realize its potential. This capital often comes from private sources, as is the case with the billion-dollar venture capital and private equity funds that exist in California.

Alternatively, startups can approach the government for financing through direct capital injections or indirectly through sovereign wealth funds.

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In the 1980s and 1990s, economists were very skeptical about governments’ ability to make sound investment decisions. Arab and Latin American countries have experimented with state-led economies with poor results. Most suffered from: low economic growth, large budget deficits, spiraling public debt and long-term exchange rate crises that have become the norm.

The ineffectiveness of government as the driving force of the economy was attributed to two key factors.

First, many government officials lacked the competence to run these giant economies. This was not due to a lack of cognitive skills; rather, it was a reflection of the complexity of modern economies and the need for private entrepreneurs on the front lines – those with unique, differentiated knowledge and who are motivated by profit – to be at the center of decisions about where scarce capital should be directed.

China’s experience suggests that the increasingly popular model of state capitalism has flaws that policymakers should guard against.

The second was the threat of crony capitalism, which sometimes left officials vulnerable to corrupt capital allocation decisions. Inefficient, politically connected companies managed to secure government support, leading to economic stagnation and deterioration of state finances.

This “Washington Consensus” – referring to the International Monetary Fund and World Bank’s view that government should take a backseat – did not last long. The 2008 global financial crisis swung the pendulum sharply back towards a belief in state-led capitalism as a means of sorts.

Those concerned about the government’s ability to steer the ship have come to see it as the lesser of two evils for two reasons, as rampant private sector irresponsibility on a global scale has nearly led to the collapse of the global financial system. The strong, positive contribution that the Chinese government has made to its own outstanding growth has also helped to rebuild state-led capitalism.

It was at this point that the Gulf countries began to write their own economic visions. Inspired by China’s recent experience and the historical experience of countries like Japan and South Korea, some governments have tried to create commercial ecosystems in which the state plays the role of a strategic venture capital investor.

The business acumen of the private sector was a welcome addition. However, some private fund managers have flaws that make them unsuitable to lead in emerging sectors such as renewable energy and military production. Most significantly, these investors are often conditioned to favor projects that deliver returns within five years or less, even though many of the benefits of technologies like solar power literally take decades to materialize.

Moreover, sectors such as defense manufacturing require coordination among many related sectors, and usually only the government has the authority and patience needed to keep everyone moving in the same direction.

The Covid-19 pandemic has reinforced this thinking as Gulf governments gain confidence in their ability to manage systemic crises and steer the economy to the right sectors.

However, a recent paper by Dr. Emanuele Colonnelli (University of Chicago), Dr. Bo Li (Peking University), and Dr. Ernest Liu (Princeton University) suggests that some policymakers may want to re-evaluate their approach.

For the Gulf countries, there is a clear warning that the government’s role as a strategic venture capitalist may need to be modified

Dr. Colonnelli and his co-authors used advanced experimental and research techniques to understand the advantages and disadvantages of government involvement in investment decisions. Talking to private investment funds and companies looking for capital, they came to two important conclusions.

First, the average Chinese business is wary of government-linked investors. Second, the best-performing private companies proved to be the most cautious – those most likely to create jobs and contribute to economic growth.

Further analysis revealed reasoning reminiscent of the Washington Consensus: political interference in decision-making – that is, civil servants instructing companies to make decisions that may sometimes be commercially unwise due to external political considerations – is the primary reason why government capital is unattractive for private companies.

Moreover, according to the findings of Dr. Colonnelli and his colleagues, private companies have lamented the lack of professionalization of some civil servants associated with these investment funds, especially in cutting-edge sectors such as technology, where the consequences of under-informed but over-confident interference by officials can have disastrous consequences.