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For tourists visiting Panama, the sight of dozens of ships queuing in the Pacific haze to enter the Panama Canal is a spectacular scene and a reminder of the canal’s importance to international shipping and world trade.

For the centre-right government of this tiny Central American country of 3m people, however, it is an uncomfortable indication that one of the most celebrated feats of 20th century engineering is finding it hard to cope with the demands of modern life.

“We’re reaching full capacity,” says Francisco Míguez, finance director of the state-run Panama Canal Authority (ACP). “We thought we would hit it by 2012 but it is now more likely we’ll reach it in 2009-2010.”

To bring the canal into the 21st century, the government of Martín Torrijos called a referendum on an ambitious project to add a third set of locks, which would roughly double capacity, now about 330m tons a year. The bigger locks would also allow wider, so-called post-Panamax vessels to use the canal.

The plan, which the authorities believe will cost up to $5.25bn over seven years, would involve deepening and widening the canal as well as cutting an access route to the new locks.

Mr Torrijos’s administration insists that a yes vote in Sunday’s referendum would be a vital step in ensuring Panama’s future economic growth. Some estimates suggest that expanding the canal, which accounts for about 5 per cent of the country’s gross domestic product, would boost annual growth by at least one percentage point.

It also insists that a defeat would make it increasingly difficult for the government to reduce unacceptably high poverty levels.

Strolling past Panama City’s swanky skyscrapers it is sometimes hard to imagine that as much as 60 per cent of the population lives beneath the poverty line. But take a detour from the tourist trail in the old city and it soon becomes apparent what the government means.

Clothes-lines on dilapidated wooden balconies display row on row of threadbare clothes, shoeless children beg for money in the street and men with hollow cheeks and glassy eyes lie listlessly on park benches. Doors with peeling paint hide dark hovels divided into family units by old sheets draped over pieces of string.

The ACP, which has operated the canal since the US handed it back to Panama in 2000, is doing its best to boost the canal’s current capacity. But it admits that it is not enough to keep pace with the growth in demand.

Alberto Alemán, who heads the ACP, argues that one problem is the growth in container shipping, which is increasingly associated with the post-Panamax vessels that do not fit through the canal’s antique locks. “The canal is losing competitiveness,” he says.

A second problem is potential competition from other countries. This month, for example, President Enrique Bolaños of Nicaragua sought international support for a canal project linking the Pacific and the Atlantic that would cost about $18bn and take 12 years to build. “It is not only feasible but it is necessary,” he told a meeting of western hemisphere defence ministers.

In the referendum, the no campaigners say there are good reasons for voting against the plans, starting with costs and financing. Miguel Antonio Bernal, leader of the no campaign, believes the expansion plan will end up at $10bn-$12bn – a price that, given Panama’s poverty levels, is impossible to justify. “We want a canal that serves the country – not a country that serves the canal,” he says.

Another complaint is that expansion could threaten the environment because of the extra amount of water required for the new locks and the flow of harmful sea water into fresh water supplies.

Supporters of the project reject such arguments. Mr Míguez, who heads the ACP’s expansion plan, says there is virtually no possibility of going over budget because it is not a green-field project and involves no new technology. “We are basically talking about dry excavation, dredging and pouring concrete. It’s not that complicated.”

Guillermo Chapman, a former economy and finance minister, calculates debt repayments including interest would be less than $200m in the project’s first year, and could be covered from current annual income of $1.4bn. The government claims the new, much bigger locks would use 7 per cent less water than the existing ones, much of which would be recycled.

For now, the government and the ACP are taking some reassurance from recent polls suggesting that about two-thirds of Panamanians will vote yes. But, as Mr Bernal points out, two referendums during the 1990s went against the opinion polls.

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