(Fortune Magazine) -- If Vinod Agarwal has his way, Hyderabad, a city known for its pearls and Old World charm, will soon become the capital of India's semiconductor industry.

Agarwal, a Silicon Valley researcher-turned-entrepreneur, has teamed up with the state of Andhra Pradesh to build a $3 billion fab -- India's first high-volume, advanced-technology chip plant -- on 1,200 acres of government land on the outskirts of Hyderabad. AMD, the world's second-largest chipmaker, has licensed its process technology; electronics manufacturer Flextronics is investing; and the Indian government is expected to take a 25% equity stake once it finalizes a semiconductor policy it has been debating for the past year.

Most of the funds for developing Fab City, as the technology park is called, will be provided by SemIndia, a consortium of nonresident Indian entrepreneurs of which Agarwal is chairman and CEO. In addition to the SemIndia fab, the park is expected to have additional factories making solar cells, flat-screen TVs, and other electronics products. The first phase of the project, a $100 million test-and-assembly line, is scheduled to be completed in a year. Agarwal says funding has been secured, but only one investor has been named.

India is expected to consume $160 billion worth of electronics a year by 2016, according to Frost & Sullivan, a U.S. consultancy, and the semiconductor portion of that could be as much as $40 billion. But there are only two chip-manufacturing plants in the country, both government-owned and both using outdated technology. "With advanced-technology chip manufacturing, India would have the entire ecosystem necessary to fully exploit local consumption as well as the global markets," says Agarwal. "The time is right."

Dayanidhi Maran, India's 40-year-old IT and Communications Minister, agrees. "We have to make a start somewhere with the latest technology," says Maran, who has been spearheading the government's semiconductor initiative. "We just cannot say it is capital-intensive and let it go. This same project would cost us $10 billion if we put it off for another three years."

But getting anything off the ground in India is fraught with challenges. June Min, a Korean who was the first to announce plans to build a fab in India two years ago, has yet to accomplish his mission. And Intel has been negotiating for two years to expand its R&D operations and build a chip plant in Bangalore. One government official, who asked not to be named, says both sides had huge wish lists, and the government wasn't ready to compromise. "When other countries offer more subsidies," the official says, "it is natural for the company to invest there rather than haggle with India."

Fab City has its detractors, who believe the investment is too risky. "Setting up a fab in India is going to be an uphill task for anyone," says C. Dayakar Reddy, managing director of MosChip Semiconductor, one of the few fab-less chip-design companies in India, whose customers include IBM-GES and Panasonic. "You need to have enough experience, funding, and top-notch technologists, which India at present does not have, to get the whole thing going." Reddy says MosChip sends its designs to Taiwan to be manufactured. "We dare not bring the finished chips back to India for testing and adding software," he says. "We ship it to the U.S. directly, because once they come here and are again shipped out, we are slapped with excise taxes. The government thinks we are trading, when in fact it is our own IP. Unless there is a rational tax structure, manufacturing here is a no-win situation."

If the government doesn't come up with a semiconductor policy soon, Agarwal's project could be in trouble. But some take a longer view. "When Texas Instruments came to Bangalore to set up a design center 20 years back, there were similar hurdles -- no software policy, no ground rules, zilch," says B.V. Naidu, director of Software Technology Parks of India in Bangalore. "We're seeing the same when it comes to semiconductor manufacturing." Adds Raja Kumar, CEO of UTI Ventures, an Indian private-equity fund: "Even to dream of a project this size in India is commendable. And if there is proactive support from the government, we believe this could take off."