Andrew Marshall, Jakarta – Indonesia is on the edge of an abyss. The country is lurching towards economic disintegration, analysts say, and the only thing that can halt its catastrophic decline is a return of the investor confidence which collapsed last year to set the crisis in motion.

But such a leap of faith by international investors is further away than ever amid fears of another explosion of mass unrest.

The immediate priorities are to stave off widespread starvation, create a credible government in a country still in political limbo after the resignation of former president Suharto on May 21, and avoid a repeat of the mid-May riots that ravaged Jakarta and left almost 1,200 dead.

Only when – and if – this is achieved can serious talk of a recovery even begin. "In the next two years, the priority must be social cohesion," Mari Pangestu of Jakarta's Centre for Strategic and International Studies said. "Then you can talk about growth and recovery."

Survival first, recovery later Indonesia signed a new accord with the International Monetary Fund last week, opening the door for a resumption of stalled international loan payments likely to exceed $45 billion. While previous agreements had concentrated on economic reform and dismantling monopolies, the new deal had a much more basic focus – fighting deepening hunger and deprivation.

The IMF said Indonesia's economy would contract more than 10 percent this year with inflation expected to reach 80 percent. But many economists say the picture will be even gloomier. Most expect the economy to shrink 15 to 25 percent in 1998. Pangestu said more than 100 million people – half the population – would be below the poverty line by the end of 1998. The distribution network, which was dominated by ethnic Chinese who have fled the country after being targeted by mob violence, is in tatters. Coupled with a severe drought and the soaring cost of imports, this has sent food prices spiralling. A period of vicious stagflation – sharp economic contraction coupled with fierce inflation – is inevitable.

Analysts say the risk of mass unrest is huge. "You cannot tear such a massive hole in the economy without causing deep suffering, dislocation, prostitution, disease, anger, frustration and death," said Jeffrey Winters, professor of political economy at Chicago's Northwestern University and an Indonesia specialist. "That is the time bomb Indonesia faces."

Many analysts say large-scale international humanitarian aid will be needed to keep starvation and unrest at bay. "There is no precedent for what is happening in Indonesia at the moment," said Bruce Rolph, head of equities at Jakarta's Bahana Securities. "We don't need marginal improvements, we need fundamental measures including a large injection of foreign aid."

The risk of an uprising from the lowest ranks of society is matched by the danger of further instability at the top. New President B.J. Habibie has promised parliamentary elections, held under less restrictive political conditions, by May next year and says a new president will be elected by the 1,000-member People's Consultative Assembly by the end of 1999.

Many analysts say Habibie lacks credibility both at home and abroad and the country cannot afford to wait so long for the installation of a president with wider popular backing. But some argue elections and attempts to build a new political landscape would only lead to chaos at a time of such economic depression.

Economists say Indonesia needs a government strong enough to tackle the crucial restructuring of the crippled banking sector and ailing state firms in the face of powerful vested interests. "The steps agreed with the IMF are encouraging but the key questions are about the political will to implement them," said Jakarta-based business analyst Stephen Rogers. "An indicator of their commitment to really restructure the economy and get out all the bad eggs will be whether they carry out audits of public companies and give the bank restructuring agency the independence to push the bad banks into bankruptcy."

Fears of further violence and political turmoil have savaged the rupiah, which has sunk to around 15,000 against the dollar – a dive of more than 80 percent since last July and 25 percent since Habibie came to power. The stock market is virtually dead. "The bellwether indicator of sentiment is the currency. The stock market is irrelevant as an indicator because there is net negative equity overall – there is no real equity in the market. Meanwhile, the rupiah looks set to head to 20,000," said Bahana's Rolph.

Rising from the rubble Indonesia's crisis, which began this time last year as a sudden loss of market confidence and a speculative flight from Asian currencies, has become far more than an issue of sentiment. Unable to service their debts or pay for essential imports, companies have halted operations and firms have been unable to increase exports despite the competitive benefits of the rupiah's fall.

Winters said the economy had passed the stage where companies were merely winding down and now Indonesian firms were ceasing production completely and laying off workers. "Now that this phase has been entered, the time, effort and resources needed to recover are much greater," he said.

Analysts say Indonesia's recovery, when it comes, will begin with the export sector and a slow export-led upturn could begin in the second half of next year. But a corporate turnaround will require far more than the debt-restructuring package agreed in Frankfurt in June, which gave firms eight years to pay off their debts with a three-year grace period when only interest need be paid.

Analysts say most firms are unable even to meet interest payments and a central prerequisite for any recovery is an injection of fresh capital and a realisation by foreign banks that a huge portion of corporate debt must simply be written off. "The real issue for Indonesia's corporate sector is the extent of the write-offs that inevitably must be made," Bahana's Rolph said. "Whether it is 50 percent which has to be the absolute minimum or 70 percent which is conceivably more likely, until you get that corporates have got no hope at all of any kind of recovery."

Another risk to Indonesia's attempts to export its way out of the crisis is a further deterioration of Japan's economy. In 1997, 23.9 percent of Indonesia's exports went to Japan. Indonesia's eventual recovery will also require strong inflows of foreign capital. But the return of private sector investment, which normally would follow an IMF stamp of approval like the accord signed last week, has so far been absent.

Analysts say that despite the trauma suffered by the ethnic Chinese, they are likely to be the first major investors to return. If they do, it will be an early indication of an upturn. "The confidence of the ethnic Chinese is crucial to the recovery. But so far the government has done nothing to bring to justice those who attacked, sexually abused and murdered the ethnic Chinese in the riots," said Andy Tan, general manager of Standard & Poor's MMS in Singapore.

Domestic consumption will take years to recover. Pangestu said per-capita GDP is unlikely to regain its pre-crisis levels for a decade. And with millions of children dropping out of school and the health system facing increasing strain, long-term economic scarring will be severe. "The damage was inflicted very quickly," Pangestu said. "But it will take years to get back what we lost."