The 3.8 billion ringgit ($1 billion) project is badly needed to ensure adequate water supplies for the fast-growing capital, Kuala Lumpur, and surrounding areas of the heavily populated state of Selangor. It involves building a dam in neighbouring Pahang state and piping water to Kuala Lumpur and Selangor.

"It is an urgent issue to have access to water resources outside the state (of Selangor) to meet rising demand for water," the lending agency, the Japan Bank for International Cooperation, said in statement posted on its Web site.

Japan first agreed in principle to give the Malaysian government a soft loan for the project two years ago, but the final loan agreement was delayed due to some concerns over the environment and over the displacement of people by the dam.

"We have of course come to the agreement (on that)," the bank's representative in Malaysia, Naomi Miwa, told Reuters on Monday, adding that final discussions had focused on the loan's requirement for monitoring of environmental and social impacts.

"Regular monitoring among the stakeholders will take place."

The project will require relocation of over 100 of Malaysia's aboriginal people, Orang Asli, in Pahang, said a senior official at the Malaysian energy, water and communications ministry.

"It's a chance for the federal government to upgrade these people's standard of living," Ching Thoo, the ministry's principal assistant secretary, told Reuters on Monday.

"It will be better than what they have now," he added.

Under the project, water will be piped 45 km (28 miles) from the new dam in Pahang state to Kuala Lumpur and Selangor.

Work could begin as early as this year and take about five years to complete, Ching said. "Maybe the third quarter of the year, we could see some progress on the project," he said, adding that land had already been acquired at the site for the dam.

The project promises to be a shot in the arm for Malaysia's construction industry, which is aching for new work after the country put most major state projects on ice over the past 18 months to help rein in a chronic budget deficit.

There is also the prospect of another related water project, worth as much as 2-3 billion ringgit, to build a Selangor treatment plant for the water piped in from Pahang, Ching said. But he said financing for this had yet to be decided.