ANALYSIS-Huge aluminum project stirs Paraguay investment hope

* Rio Tinto Alcan explores $2.5 bln Paraguay investment * Project could give positive signal to other companies * Legal security, corruption barriers to investment By Mariel Cristaldo and Daniela Desantis ASUNCION, Dec 21 (Reuters) - A proposed $2.5 billion aluminum smelter gives Paraguay a chance to shake its reputation as one of the most corrupt countries in Latin America and woo more major investors with its cheap hydro-electric power. Paraguay, a soy- and beef-exporting country, has long sought to diversify its economy, but its notorious contraband industry and culture of bribery have scared investors. Rio Tinto Alcan, a unit of global mining giant Rio Tinto , signed a letter of intent last week with the state power company ANDE to begin negotiations for a power purchase agreement for an aluminum smelter. The smelter, if it is built, would be one of the biggest investments in the country's history, eclipsed only by two massive hydroelectric plants built jointly with its two big neighbors, Brazil and Argentina, more than 20 years ago. Construction would begin in 2014 on the proposed plant, which would go on line in 2016. Projections say the smelter would provide 3,000 direct jobs and produce 480,000 tonnes of aluminum per year using a dedicated transmission line provided by ANDE and financed by Rio Tinto. The government hopes a success story based on competitive costs for its energy supplies would bring more economic activity to the small country. But experts warn there are challenges. "What's important is that the rules don't change along the way and the state companies involved can build the required infrastructure on time," said former Finance Minister Cesar Barreto. A success story would "give a very clear signal to to other companies that are intensive energy users that Paraguay can sign long-term contracts," he said. CHEAP POWER, LACKING TRANSMISSION Itaipu dam on the Brazil-Paraguay border is one of the biggest hydroelectric generators in the world, supplying much of Brazil and Paraguay with cheap energy. But Paraguay has not been able to attract big industry to use its excess output due to the lack of power transmission lines and decades of corruption scandals. Transparency International, an agency that measures corruption around the world, gives Paraguay one of the lowest ratings for transparency in Latin America. Paraguay is notorious for contraband manufacturing of everything from cigarettes to electronics under fake brand names, that are sold in neighboring countries. Foreign companies often run into heavy bureaucracy, lack of infrastructure, corruption and a weak judicial system. British American Tobacco shut down a factory in 2003, complaining of fake cigarettes. Disney suspended distribution of its films in Paraguay for a time over piracy concerns. President Fernando Lugo, a former bishop, is a leftist who has sworn to do more for the country's poor. But unlike leftist allies in Bolivia and Venezuela, who have nationalized sectors of the economy, he seeks foreign investment to reactivate the economy and generate jobs. Manuel Ferreria, an economist, said the aluminum smelter project would help Paraguay diversify its exports. "This type of large-scale investment by big foreign companies can only work as far as the government is willing to open the doors because Paraguay does not have a very fluid system to receive this type of investment," Ferreria said. "It's going to depend on the people who work on promoting this, who can help the company to resolve issues that come up. This is an intention at this point, there's a lot still to do," he said. Paraguay's economy is expected to contract 3.8 percent this year, its worst performance in at least a decade, due to a drought that hit cattle and soy at the same time as the global slowdown. Agriculture accounted for an average 25 percent of gross domestic product over the past five years, while industry contributed only 14 percent, according to central bank figures. (Translated and edited by Fiona Ortiz; Editing by David Gregorio)