Ajay Shah: A fab by government is a wild idea

If the government wants to foster high technology in India, interventions should be designed in a way which have a public goods character.

The "Semindia" project has made waves in recent months. A bright future is held out for India in making integrated circuits (chips). There is no case for the government to get involved in such a project through equity capital, subsidised financing, or land. The government must restrict its activities to facilitating public goods such as infrastructure. What factories are built once these public goods are in place is best left to the private sector.

In the 1980s, there was a great scare in the US when Asian chip vendors were taking away the market share in memory chips. There was a great scare that this was of strategic importance for the US. I have grown to be cynical about the word "strategic". When someone says that computer chips are strategic or oil supplies are strategic, that is often a code word for saying that we should suspend common sense and agree with whatever is about to be proposed.

Big government swung into the game in the US, with a project named "Sematech". Many years later, we can evaluate the results. The memory chip business moved first to Japan and then to South Korea and Taiwan. It is now understood to be the low-margin, capital-intensive, commoditised end of the business. There is little profit to be made in making memory chips. The high profit end of the business is in CPUs, and this stayed in the US anyway owing to the top-end human capital which was in the US. Looking back, the moral of the story is: there was no role for industrial policy in the US on the subject of fabs.

This is yet another example of one big lesson that economists have understood for a while now: that "Industrial Policy" is a bad idea. Industrial policy involves a government that can run "corporate welfare programmes" for some firms. The government is supposed to choose what industries are "good", and what management teams are "good", to put public money behind them. But does a government know more than an entrepreneur about what the future holds? And can a government ever choose the best management teams to back? Picking industries and picking teams are things that a venture capitalist does, not a government.

There is no part of technology that is as glittering and impressive as a semiconductor fab. Any politician who is taken for a tour of one will be highly impressed. If the politician is not well-versed in economics, he is not allergic to industrial policy. It is then easy to talk him into putting public money behind such a project "of strategic importance to the nation". But when the man writing a cheque understands nothing about the project for which money is being given, mistakes are certain.

Public sector participation for a fab in India is an entirely dubious idea. One clear problem is capital intensity. A fab costing $3 billion might employ a few thousand people at most. It is a capital intensity of roughly Rs 4.4 crore per employee. In contrast, the mainstream services exports work in India has a capital intensity of at most Rs 0.1 crore per employee. It is not at all obvious that India has a natural comparative advantage in the fab business, which is roughly 44 times more capital-intensive than labour-intensive services work.

A particularly unhappy feature of the Semindia project is talk of 1,200 acres of land. A standalone fab costing $3 billion occupies 25 acres (e.g. TI's DMOS 6 fab in Dallas in Texas). A full mini-city with a fab costing $3 billion occupies 75 acres (e.g. Intel's Fab 18 in Kiryat Gat in Israel). It is hard to explain politically allocated land of 1,200 acres for Semindia.

In the Budget speech last month, Mr Chidambaram promised support for the semiconductor industry: "I propose to use the existing vehicles of viability gap funding and the India Infrastructure Finance Company Limited (IIFCL) to create a window to provide equity participation and/or viability gap funding to the new ventures". It is not clear to me what public goods are produced when someone builds a fab. It is just a factory. Just as the government should not be involved when someone builds a factory that makes trucks, it should also not be subsidising a factory that makes semiconductor chips.

All this is not to say that fabs are not desirable. India should, of course, be thrilled if a serious semiconductor firm like Intel or TI or AMD voluntarily choses to build a fab in this country. This will depend on what we do on roads, water, electricity, and airports. A politician suffering from fab envy should do his part, which is to foster roads, water, electricity and airports. While fabs have very little employment, they require top quality Ph Ds. This is where (say) Israel wins hands down over India""they have world-class universities while we do not. If a minister is worried that India does not have fabs, he should take on the rot in our higher education. But the business case for a fab should be judged only by private sector equity investors, never by a politician, and the fab should always have to buy land from the private sector at market prices.

If the government does want to foster high technology in India, interventions should be designed in a way which have a public goods character. The most effective way to do this is to emulate the Defence Advanced Research Projects Agency of the US. DARPA gave out thousands of small grants to scientists to build defence-related technologies. DARPA contracts were awarded by a meritocratic system. Contracts have to yield tangible deliverables, which helps to keep the pressure up. DARPA tended to fund a large number of small projects, which spreads the risks and increases the chances of reaching a few geniuses.

A DARPA-style meritocratic mechanism for giving out research contracts is the best way for the government to foster high technology, whether it is by companies or by universities. There are enormous spillovers of knowledge to the economy when teams in the country learn new things. There is a public goods aspect here. As an example, the global Internet grew out of technologies built on DARPA contracts, and US companies have reaped enormous returns to the public investment in DARPA funding. In contrast, public sector involvement in Semindia does not produce public goods.