China has launched a drive to create a domestic venture capital industry to fund companies in high-growth sectors such as technology. The move is likely to increase competition and reduce returns for foreign private equity groups.

The initiative by the National Development and Reform Commission, China's chief economic planning body, is designed to foster homegrown venture capitalists by offering them better tax treatment and easier exit routes than foreign rivals.

The NDRC's rules encourage local governments to provide direct investments, loans and debt guarantees to domestic venture capital funds, which will be required to have only Chinese nationals among top management and investors.

The measures, expected to come into force in March 2006, could help address the funding problems of most Chinese small companies, which are regularly shunned by state banks who favour government-owned enterprises.

"This is a first step, but eventually these funds could become viable competitors for foreign venture capital groups," said Maurice Hoo, Hong Kong-based partner in the private equity group of the law firm Paul, Hastings, Janofsky & Walker.

The NDRC's move mirrors initiatives in Japan and South Korea and could deepen fears that negative sentiment towards foreign investors in Asia is spreading, as governments and regulators become increasingly hostile to the large profits made by overseas private equity groups.

Japan is also considering rules that would make it almost impossible for foreign companies to conduct all-stock mergers with local rivals.

The move by the Chinese authorities - named "Measure No 39" - comes after several foreign venture capital groups reaped substantial returns from the sale of their investments in Chinese companies, particularly in the technology sector.

Analysts estimate that over the past two years, some nine Chinese companies have earned their foreign venture capitalist backers returns of 10 times their investment.

The success of recent Chinese ventures, and a partial relaxation of foreign exchange rules, has spurred increased interest from foreign funds, with an estimated US$5bn of overseas venture capital looking to invest in the country.

Under Measure No 39 domestic venture funds would require a capitalisation of just Rmb30m (US$3.7m), compared with Rmb40m for foreign venture capitalists.

The minimum investment amount for each investor in domestic funds would be Rmb1m rather than the Rmb8m required of investors in foreign funds.

Domestic funds would also benefit from a more streamlined system of government approvals and less strict regulations.