Why the Chinese are spending $40bn in Central America

For centuries the world's leading powers have looked for the best way to transport goods between Central America's Pacific and Atlantic coasts. Charles V, Holy Roman Emperor, was one of the very first to try and initiate a water passage. In 1534, he ordered the Panama regional governor to survey a route to the Pacific. At the time, the governor came back with the opinion that it was simply impossible to accomplish. More or less following the course of the Panama Canal, this proved false information.

Later France (unsuccessfully) and America (successfully) were to follow up with canal attempts of their own. Last month, China signalled its arrival with a $40bn deal to build a rival to the Panama Canal in Nicaragua. In geopolitical terms this is huge. America has used gunboat diplomacy and outright war to defend the Panama Canal, ensuring its control over the most strategically important waterwayin the western hemisphere, and Washington won't want a China-backed rival. New World readers should take note too. This is another reminder of why we should be looking for ways to invest in Central America - one of the world's most exciting economic regions.

The challenges facing the Chinese

The task facing the Chinese consortium certainly looks daunting. Building an interoceanic canal of that size is an enormously complex and expensive task. Then, assuming that you do pull it off, you'll have to enter a price war to win business off an established competitor. Not ideal if you're servicing tens of billions of dollars of debt.

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Laying a rail track is cheaper of course. And China has proposed several dry canals' ie, railways in other countries such as Honduras and Colombia. But the long-term economics are less attractive, as switching heavy shipping containers onto trains and back onto waiting boats is more expensive than just sailing a boat down a canal.

Even if you somehow solve the engineering and financial problems there is one more challenge politics. Back in 1903, America got its way by supporting Panamanian separatists against Colombia and then signing a very favourable deal with the new state. In other words, they were basically able to ride roughshod over local concerns. Nowadays that's not so simple. To get a massive nationwide infrastructure project like this off the ground you're going to have to negotiate with everyone from corrupt local politicians who want their cut, to concerned environmental NGOs.

Backing from the Nicaragua president

All of the proposed routes for a Nicaraguan canal involve immense engineering challenges, but ones that should be solvable. Nicaraguan press report that the Chinese consortium is backed by China Railway Construction Corp a huge state-owned enterprise (SOE) with experience in putting together vast infrastructure projects. Anyway, if US engineers were able to build the Panama Canal 100 years ago, it seems churlish to suggest that the Chinese couldn't do it today.

Likewise, China, which recently overtook America as the world's biggest trader, could probably guarantee enough shipping for the new route to prevent the need for a price war. As for the politics, that's more complicated. Nicaragua's president, Daniel Ortega, is former guerrilla who spent years fighting US-backed forces and is certainly no puppet. Yet so far he clearly thinks the Chinese alliance will help him and he succeeded in rushing through the canal legislation with the minimum of fuss.

All in all, this project still has plenty of challenges but it certainly looks the most likely for a long while.

Why this matters to us

The fact that China is willing to spend so much political and financial capital to build this canal shows just how important Central America is becoming. The small isthmus forms a natural land bridge between the northern and southern hemispheres, while the Panama Canal links East with West. This is nothing new, but as South America, Asia and Africa's share of world GDP and trade has raced up in the last ten years, it has made the region's bridge status' more and more valuable.

But this story isn't just about goods passing through Central America. The region has a lot to offer in itself. Central America is made up of Belize, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Panama and is home to around 41 million people. The largest country is Guatemala with 14 million people, the smallest is Belize with just 300,000 people, while the rest have between three million and seven million people each.

Taken on their own, these economies are too small and poor to attract much investor attention, but as a group, they share several positive traits. They all have good demographics with young and growing populations. They're also all starting to open up their economies. The first major free-trade agreement (FTA) was with the US in 2004. That's been followed by one with the EU, which should come into force later this year. These deals are opening up large, new markets for Central America's niche agricultural exports from quality rum and cigars to masses of banana and coffee.

More surprising is that the FTAs are also helping the region expand its manufacturing base. Central America is home to lots of light manufacturing, such as textiles and electronics, where its main competitors are other low-cost producers in Asia. By signing up to these FTAs, Central America is gaining cheaper access to the lucrative European and American markets than its Asian rivals.

Longer-term, this growth in manufacturing could be helped by changes in China. Michael Henderson at Capital Economics believes that "as Chinese manufacturers have begun to edge up the value chain, their dominance in sectors such as textiles has started to slip. This is good news for many Central American economies."

Slashing energy imports

Another boost should come from improving infrastructure especially energy. Because they are so small, Central American countries were typically unable to finance large, efficient coal or gas-fired power stations. Instead, they relied on smaller, less efficient oil-burning plants. That was bearable in the '80s or '90s when oil prices were low, but the massive price increases in the last ten years or so have left these countries with a large and volatile energy bill. The import costs have hit their macroeconomic position, while the lack of reliable electricity has stunted economic development.

But now that's starting to change. Because, while Central America hasn't got much oil or coal, it has plenty of wind and solar energy potential. So, unlike the UK, where renewable is often seen as an expensive, ideological option, in Central America it offers a great way to cut energy imports.

Over the last five years a number of Central American countries have started to wean themselves off oil generators. Around half of Nicaragua's electricity demand is met by renewable energy, up from 20% just a few years ago. So far, the country is on track to meet its goal of producing 94% of electricity from renewable sources by 2016. The same story can be seen across the region.

Panama, El Salvador and Honduras all generate more than 50% of their electricity from renewable sources while Costa Rica gets almost 100%. As more renewable projects emerge, they will help governments shore up budgets and create a more stable environment for businesses and consumers. History has shown, at the early stages of development at least, that a more abundant, reliable supply of energy normally leads to more economic growth.

The final boost is coming from improved regional integration. I was speaking about this with Luis Velazquez Quiroa, a former Guatemalan economic minister, and he expects it to boost economic growth. He admitted that regional initiatives are nothing new "the first integration effort was in 1871 and we've made 27 since then, but in the last few years we've seen real progress." This is down to both pride and realism he says. "There has been a realisation that international organisations like the World Bank or IMF don't want to deal with small countries, they'd rather work with a regional association. You also notice that more people are proud of being Central Americans and see themselves in that way."

A great way to play this story

All of the factors above look encouraging, but it's not very easy for a British-based private investor to gain exposure to the story. When I wrote about Central America back in February, I suggested that Copa Holdings (NYSE: CPA), the region's leading carrier, would be a good way to play the story. Since then the share is up 26%, but today, I've got another, slightly riskier, way to invest in Central America telcoCable & Wireless Communications (CWC).

At first glance it may seem like an odd choice. CWC has its roots in an array of telegraph companies that connected the distant points in the British Empire. Over the last 100 years, mergers, nationalisation, privatisation and a final demerger in 2010 when it split off from the larger Cable and Wireless Worldwide has created a strange company with a hodgepodge of international businesses. Since 2010, the firm has done a pretty good job of disappointing investors, but now there are signs that things are changing.

CEO Tony Rice is trying to build a "pan-American" company. It is in the process of selling off about a third of the business assets in places such as Seychelles and Macau and planning to reinvest the windfall in expanding its presence in Central America and the Caribbean. At present the firm supplies fixed line, broadband and mobile to nine million people in 16 pan-American markets.

Panama is the biggest single market for the firm, making up 30% of sales and an even higher chunk of earnings. After Panama, the next biggest markets are Jamaica, the Bahamas and Barbados, where business is more subdued. But what's interesting about CWC and what makes it a bit of a punt is how it plans to spend its billion-dollar divestment windfall.

Rice has highlighted Cuba, Puerto Rico and the Dominican Republic as potential future markets. CWC can also beef up its holdings in existing markets, where it often works in joint ventures with governments. For example, Rice has expressed interest in buying out part of the Panamanian government's stake in the firm's local operations. Rice is also moving the management team to a new headquarters in Florida, so that they'll be closer to customers.

Of course, there is plenty that could go wrong. If CWC ends up overpaying for assets the share price will suffer. But if management pull this off, they'll create a telco with a unique footprint in fast-growing Central American and Pan-American countries. That should result in growing sales, as increasingly affluent Central Americans switch over to data-hungry smartphones. It would also make the firm a useful takeover target for larger Latin American rivals such as America Movil. There's no doubt that this is a risky investment but one with plenty of potential upside.