China‘s Xi Jinping recently declared that he wants China to rank as one of the world’s most innovative countries by 2020 and to top the list by mid-century. Going by past practice, this probably means a lot more money being poured into dodgy start-ups and ill-conceived high-tech schemes. There’s a better model to be found, however, one that’s surprisingly close to home: the southern boomtown of Shenzhen.

The city‘s Nanshan district, home to a huge High-Tech Industrial Park, is now China’s richest, with a higher per capita gross domestic product than even capitalist Hong Kong, just across the border. Indeed, Shenzhen‘s rapid success could well be more remarkable than the latter’s: Little more than a fishing village in 1979, when Deng Xiaoping decided to launch China’s reforms in a special-economic zone there, Shenzhen has since grown into a megacity of more than 11 million people with a GDP five times Macau’s. At an average of $67.54 per square meter, real estate prices are higher than anywhere in the U.S.; the city will soon be home to the world’s fourth-largest skyscraper. It‘s little wonder that in 1992, when support for his reform agenda was flagging, Deng returned to the city to remind Chinese of the virtues of entrepreneurship and private enterprise.

Today some 8,000 tech companies have set up shop in the city, including Internet giant Tencent and telecommunications company Huawei Technologies, as well as the world’s largest drone-maker; the $3 trillion Shenzhen exchange is devoted to high-growth tech start-ups. Beijing Genomics International, a public-private partnership, provides rapid DNA data downloadable anywhere in the world via Amazon cloud services. Lighting company LEDSFilm is manufacturing the smallest and brightest studio and entertainment lights in the world.

Not every city in China can become Silicon Valley, of course. And Shenzhen had a particularly good base upon which to build, given that the surrounding Pearl River Delta is home to the thousands of nimble manufacturers that assemble most of the world‘s consumer appliances. But the city itself has gotten some key fundamentals right. 

First and foremost, it’s a true melting pot. To a far greater extent than other Chinese megacities, Shenzhen has eased the path for migrant workers to become full citizens: Anyone who buys an apartment is entitled to full residency rights. Ambitious risk-takers from around the country flock to the city to make their fortunes, unencumbered by history.

By contrast, Beijing remains the preserve of party elites, while Shanghai is notorious for shunning outsiders. In both cities, bureaucratic infighting and middle-class resistance continue to hamper efforts to liberalize the “hukou” system of household registration. That condemns low-skilled migrants to black-market status in areas like education and restricts the flow of labor to where it can most effectively help businesses grow. If China’s cities want to develop ambitious, hard-working and entrepreneurial work forces, they need to do better at welcoming newcomers who embody those traits.

Second, Shenzhen has created the most business-friendly environment in China. It’s relatively easy to set up a company and to transfer funds overseas. The World Bank generously estimates it takes more than 31 days and 11 different procedures to start a business in China. Officials in Shenzhen’s Qianhai Enterprise Zone boast they can register a foreign-invested firm in eight days. Thriving venture capital and private equity firms now fill the city, which helps foster risk-taking.

Given its lack of natural resources, Shenzhen has focused instead on freeing people to innovate: Together the government and local companies invested more than $3 billion in research and development last year, nearly 6 percent of GDP; the nationwide average is only 2.3 percent. All across the city, posters declare that “innovation (is) encouraged and failure tolerated.” City officials actively promote more open financial markets, so that entrepreneurs have an easier time tapping funding.

Most importantly, rather than heeding government diktats about what and how much companies should produce, the city’s thriving private-sector competes fiercely to develop products that can survive in a cutthroat market. Elsewhere in China, the government still coddles state-owned incumbents despite their excessive indebtedness, poor record at creating new jobs and overall inefficiency.

Finally, in order to thrive, new businesses need a solid regulatory structure that consistently enforces clear rules. Many local lawyers are licensed in both Shenzhen and Hong Kong, making cross-border agreements easier. A local free-trade zone now offers Hong Kong legal adjudication for companies fearful of more capricious mainland courts and regulators.  

Deng’s reforms in 1979 were rooted in a single thought: They empowered individuals and promoted entrepreneurialism, rather than reinforcing the state-dominated status quo. If China truly wants to build a 21st-century economy -- a must, given its shrinking population and rising labor costs -- it‘s going to have to do the same. Shenzhen is proof the formula works.

By Christopher Balding

Christopher Balding is an associate professor of business and economics at the HSBC Business School in Shenzhen and author of “Sovereign Wealth Funds: The New Intersection of Money and Power.” -- Ed.

Bloomberg