Rowan Callick – The emergence of democratic government in an independent East Timor is a miracle. The obstacles in its path, through erratic and often cruel Portuguese, Japanese and Indonesian rule, have been horrendous.

It would be entirely understandable if, early next year when the United Nations administration hands over control to the body being elected today, the new country – almost certainly led by President Xanana Gusmao, widely viewed as an Asian Nelson Mandela – celebrates, breathes a sigh of relief and relaxes.

But raw data, history and a glance around the neighbourhood warn that East Timor's troubles will then be far from over.

Its living standard is the worst in the region. With 900,000 people it is similar in size to Fiji, but its gross domestic product per head is about a quarter Fiji's, its infant mortality rate is seven times worse and life expectancy – admittedly, following a period of widespread conflict – is a shocking 50, compared with 73 in Fiji, according to figures produced by Canberra's National Centre for Development Studies.

Hal Hill, an economics professor at the Australian National University, says the country faces a choice between the outward-looking economic models of East Asia and the more closed systems of the Pacific islands – a choice that also reflects Timor's geographic location on the cusp of each region, as well as its cultural complexity.

Such tough calls are complicated by the presence of large numbers of "aid donors with their own agendas, competing for the ears of the new rulers," Hill says.

The United Nations administration that has been in place for two years opted last year for the US dollar as East Timor's currency, and has this month started acting tough to squeeze out others.

"[East Timor] has an annual GDP of just $US300 million, like a suburb of Melbourne. It's not feasible to set up a central bank and a monetary policy, so using another currency makes sense," Hill says.

The choice came down to the US dollar or the Australian dollar. Although the $A was widely circulating in East Timor, it finally ruled itself out primarily on political grounds. Its adoption would have been viewed by Jakarta as confirming its suspicions that Australia wished effectively to colonise Timor, and by Canberra as sending out a signal that it would have to underwrite the emerging State, come what may.

Language policy is another major issue that the newly elected constituent assembly – which will draft a constitution and then transform itself into a parliament before the president is elected – appears unlikely to change.

So Portuguese, spoken only by the elite 5 per cent of the population including Gusmao, Jose Ramos-Horta and Roman Catholic Bishop Carlos Belo, will become the national language rather than more widely spoken Bahasa Indonesia – no longer politically correct, but the second language of the younger generation – or Tetun, Timor's almost universally understood pidgin, or English. Many also speak their tribal mother tongue.

Hill says: "Many aid workers are doing a great job, and it's important to have such assistance during the transition."

But the danger is that an aid-dependent economy – more than half the current budget comes from aid – will result, with a bloated government sector" that will suck in much of the country's earnings to maintain it.

Under Indonesia, the bureaucracy – including teachers and health workers – comprised 33,000 people; it subsidised and distorted the budget for 25 years.

The International Monetary Fund recommends a target of 12,000 public servants. The average East Timorese public servant is paid about double his or her Indonesian counterpart, although the per capita GDP is about a third of Indonesia's. "This urban labour market is spilling over into the rural sector," Hill says.

"And already the original 'basic needs' approach to health and education has shifted towards the urban elite. There is a massive problem of the return of Timorese studying in Indonesia, returning with incomplete degrees. They have successfully applied huge pressure to allow more people to be admitted to the university, and in time it is inevitable that funds will be reallocated from primary schools."

Much of the country's modest commercial expertise departed when the traders fled the fighting of two years ago. Some trades skills are also missing, mostly filled by people flying up regularly from Darwin.

The collapse of the coffee price – halved over the past year, substantially because of the enormously increased output of Vietnam – is another problem. About 15 per cent of the workforce is directly or indirectly dependent on coffee, the dominant cash crop, which promises, when prices are better, to contribute about a sixth of GDP. But Timor does extract a premium for its coffee because it is organically grown. It is on Starbucks' menus.

Fisheries and tourism are other sectors with reasonable potential. The other big ticket item on the economic menu, though, is gas. Within 10 years, it is predicted, gas revenues will comprise half today's GDP.

Although Phillips, the US oil company that has carriage of the project to pipe Timor Gap gas to Darwin and thence across to Queensland, is in a stand-off with the UN administration over the tax rates, an accommodation is almost certain to be reached.

The new assembly in East Timor will be hoping it does so in time to get its gas field up and running before its great rival, the Exxon-led project to run a gas pipeline from PNG's Southern Highlands down Queensland's east coast.

Hill warns that "a fiscal framework, based on high aid and gas receipts which may disappoint, could create major problems" down the track. The failure of PNG itself to convert its vast resources receipts into improved living standards since independence 26 years ago is notorious.

"A dual economy is already starting to grow in East Timor between the local and the international sectors," Hill says – with the Timorese capacity to maintain subsistence farming likely to remain crucial for some years.

It is "absolutely critical," he says, to get the relationship with Indonesia right. For "East Timor will have free trade with Indonesia, like it or not" – such is its geography, with a land border with Indonesia's province of West Timor and with Indonesian islands visible from Timor. Such borders will prove impossible to police. And Surabaya, on the eastern tip of Java, is a major source of many supplies for Dili.

"There will have to be a meeting of minds between Timor's new leaders and Jakarta," Hill says – a meeting made easier by former president Abdurrahman Wahid's visit to Timor's capital Dili, and by the first major statement of his successor President Megawati Soekarnoputri, that stressed her desire too for accommodation with East Timor.

A tenth of East Timor's population is still in refugee camps in West Timor.

Timorese have bank accounts in Indonesian banks that they can no longer process, and Timorese former Indonesian public servants are asking for their pensions to be paid.

Worse, East Timor has experienced four sets of legal codes, and the assembly will have to resolve which jurisdiction to adopt and how to clarify land title. Claims made over the past two years have mostly been filed, awaiting such resolutions.

Hill says that the experience of some independence leaders being exiled in then socialist Mozambique during much of the 24 years of Indonesian rule in East Timor, as well as watching closely the travails of PNG, which is also rich in resources and coffee, and which too began life with a comparatively highly paid bureaucracy, were being drawn on usefully in Dili.

But the economy contracted by about a third in 1998 and 1999, and although it has recovered since then it remains well below its size in 1997. It will take 12 years of growth at 5 per cent a year for the country to reach the current Indonesian living standard. This process would be speeded if a large proportion of the Timorese diaspora of up to 80,000, mostly in Australia but also in Portugal and elsewhere, returned. But that is unlikely.

Australian economist Andrew Elek, who has worked in PNG where he maintains strong links, has written a paper comparing the two. Sound macro-economic management and "an early enthusiasm for nation building" would not be sufficient to produce sustained development, he says; that will take an accountable system of government as well.

"It will take at least a decade to build up a base of infrastructure, skills and institutions that can underpin sustained and increasingly self-reliant growth," he says. "The real challenge is whether it will remain politically possible to sustain the investment until there are decent systems of education, health and communications."

Learning from PNG's failings, he suggests much of the development task could be performed by private enterprises, with public servants concentrating on creating a policy environment providing the right incentives. He warns that, also learning from PNG, "the expectation of riches" from resources such as gas "can lead to a high-cost economy that is unable to diversify".

Satish Chand, of the National Centre for Development Studies, draws on the experiences of 14 Pacific island countries to make three recommendations to East Timor's emerging leadership:

"First, property rights are essential to induce investment that, in turn, is necessary for growth. Second, public sector participation has to be limited to regulation and the funding of public services, with minimal active participation of the State in commerce. Third, institutions of civil society have to be created, cultivated and protected, with particular attention to an independent, effective and credible judiciary."