In 1979, on the eve of China’s economic reforms, what is Shenzhen today was little more than a handful of rice farming and fishing villages. Today, Shenzhen is the wealthiest major city in Shenzhen in China with a GDP per capita three times the national average. Apple’s iPhone factory along employs 140,000 people in Shenzhen, China and Shenzhen is the home to many of China’s most innovative companies such as Huawei and Tencent. Shenzhen is the most dramatic example of China’s dramatic rise. It is hardly surprising that China desired to repeat this success throughout the nation. To achieve this goal, the Chinese government declared the island of Hainan a special economic zone in 1988, and implemented the same set of policies on the island. The Chinese government created special incentives to attract foreign direct investment, allowed for duty free importation of intermediate goods for export, created a modern legal code for labor and business, and granted the provincial government substantial autonomy in experimenting with new policies. Yet instead of sparking an equivalent boom, Hainan’s economy struggled. It was the slowest growing province in China between 1995 and 2010, and went from the 11th wealthiest province to the 23rd wealthiest province. Today’s podcast episode will explore the causes of the economic under-performance of Hainan’s economy.

The dramatic resurgence of domestic entrepreneurship from the late 1980s in China lies at the root of the spectacular growth of Hainan. The origins of great entrepreneurial boom of the 1980s, ironically lay in the tale end of the Cultural Revolution. Mao Zedong launched the cultural revolution because he feared that the Communist Party would ossify into a party of the establishment rather than stay a revolutionary force in society. Yet by focusing much of the violence and vitriol of the cultural revolution against the structures of the state and party, Mao Zedong weakened the loyalty and administrative capacity of these same agents. By the end of the cultural revolution, as much as two thirds of all farmers in some villages were abandoning the state controlled economy to become small farmers and businessmen. This process was especially intense around Guangdong, and in the post-reform era would transform into the rapid expansion of the Township and Village Enterprises. TVEs were companies that were often communally owned by a locality, but in practice, business authority lay in the hands of private entrepreneurs. Between 1978 and 1985, the number of TVEs in China increased from 1.8 million to 12 million. Nearly one fifth of the TVEs operated out of the Guangdong, and a disproportionate share of these out of Shenzhen and the Pearl River Delta. However, no similar wave of entrepreneurship occured in Hainan. The Nongken, or land reclamation bureau, retained its strength in Hainan. Even after a decade of reform, the Nongken system employed one fifth of the islands workforce, and generate over a quarter of Hainan’s GDP. TVEs on the other hand, did not flourish. Between 1979 and 1983 the number of TVEs in Hainan decreased by 12%, and TVEs and the rate of growth of TVEs in Hainan was one tenth that of Guangdong from 1983 onwards. There were far fewer firms in Hainan who had the ability to take advantage of the opportunities provided by the SEZ in Hainan than there were in Shenzhen.

Hainan’s failure to attract foreign direct investment and internationalize its economy compounded the weaknesses of the Hainanese economy. One of the major advantages that Shenzhen had over Hainan from the very beginning was its close proximity to Hong Kong. Although Hong Kong, under British colonial rule, transformed itself into a major financial and economy hub, many retained personal and family ties to the mainland. Investing in China in the early days of reform, and it was overwhelmingly overseas Chinese, and especially Hong Kong based investors that first invested in China. In 1981, over 50% of all foreign investment in China was concentrated in Shenzhen, and while that extreme concentration is no longer the case, Shenzhen still attracts a disproportionate share of FDI to China. FDI plays a vital role in connecting Shenzhen to global markets. Shenzhen exported about $248 billion in 2017, more than any other city in China, and 60% of these exports originated from foreign invested firms. Shenzhen’s experience is in sharp contrast to Hainan, where little FDI arrived. Hainan lacks Shenzhen’s close connection to a highly developed financial center, and so attracted little FDI despite the fact the Hainan SEZ granted foreign investors even more generous terms that Shenzhen did. Hainan recieved less than half the national average in FDI per capita compared to the rest of China in the 1990s, as the lack of an existing entrepreneurial cluster to tap into, and high cost of doing business made Hainan an unattractive site for investment.

It is this last issue, the high cost of doing business in Hainan, that I will discuss in the final part of the podcast episode. Hainan suffered from a massive speculative land bubble in the early 1990s. The average cost of housing increased five fold between 1991 and 1993, and the total amount of floor space available increased by 750% during the bubble years. This real estate bubble drove GDP growth rates to 42% in 1992, but in 1993 rising interest rates caused the bubble to collapse. The collapse of Hainan’s real estate bubble led to over 600 incomplete buildings abandoning construction, and 54% of all construction during the boom years struggled to find a buyer. The largest financial institution in Hainan, the Hainan Development Bank, collapsed in 1998 as a result of its bad debts. The massive levels of corruption were a major driver behind this cycle of boom and collapse. Bank governance in China in the 1980s and early 1990s were deeply imperfect. Most of the largely state dominated banking sector made loans on the basis of patronage and nepotism rather than sound financial practices. Corruption continues to be a problem in Hainan. In 1985, the Chinese government uncovered the first major corruption scandal, as local Communist Party officials illegally borrowed $1.5 billion to smuggle cars and electronics from Hong Kong onto the mainland. A recent study of 118 cities in China, found that Haikou, the largest city in Hainan, had the most severe corruption problem by a large margin. The primary road to wealth in Hainan was real estate speculation and corruption, neither of which resulted in political pressure on the government to improve the quality of its institutions.

Today, leaders of poor countries throughout the world look at the experience of Shenzhen in order to figure out how to replicate the process in their own countries. They look at impoverished regions of rice farms and fishing villages, and imagine creating a SEZ that will transform the landscape into high rise skyscrapers, and the most modern industrial factories. However, as the experience of Hainan shows, an almost identical set of policies can have very different results when adopted in different contexts. Economic liberalization allowed the dense network of domestic firms to take advantage of nearby FDI to create an exporting powerhouse. In Hainan, the creation of an SEZ led a speculative bubble, and the slowest growth rate in China. While policy makers in other developing nations should look to the example of Shenzhen’s SEZ as an inspiration, they should also study Hainan’s less successful experiment.