Following is an appreciation of the present situation in Indonesia.  The Dutch-Indonesian negotiations on implementation of the political and economic provisions of Linggadjati reached a deadlock about a fortnight ago. Since then there have been ups and downs in the degree of tension but talks have been abortive and all evidence suggests that the situation is now very grave.
1. Military. Military considerations have been tending increasingly to dominate all other questions and there are strong indications that a crisis involving renewal of outright warfare is imminent. The economic impasse is now being referred to as 'politico-military' impasse. We are informed that Hirschfeld, Economic Adviser to the Dutch Foreign Office who accompanied Beel and Jonkman  stated privately to the United Kingdom Consul- General that there is now no hope whatever of the Dutch-Indonesian negotiations solving the economic deadlock. (The source of the information is most confidential.) We also learn on excellent authority that Beel and Jonkman have come to the firm opinion that, if necessary, force must be used. This corroborates earlier information that the Dutch authorities recently decided, in principle, on the use of force in the last resort. The United Kingdom Military Attache, Van Der Post, talked to General Spoor this morning. Spoor spoke of increased tension in Modjokerto area instancing kidnappings by Indonesians and destruction of bridges.
The Attache observed to us that the atmosphere and content of talks was reminiscent of that on earlier occasions preceding military action by the Dutch. (This is also most confidential.) The Dutch are known to have a plan for a series of rapidly coordinated moves to occupy roads and inland cities, establish themselves on the South coast and subdue the whole of West Java as a preliminary to extending control over the remainder of the island. Far from reducing their forces, they will have well over 100,000 troops in Java by the end of July, i.e. at least a division more than before the signing of the Linggadjati agreement. They believe that they can succeed in a blitzkrieg.
Sjahrir confesses that the Indonesians lack material for offensive action but our impression from his remark is that he believes that the Indonesians can hold at least the country side, i.e. the greater part of the interior. Good opinion is that the Dutch can take the main roads and towns, the air arm having been shown to be extremely effective against Indonesian forces.
2. Economic. The Dutch opinion is that the Indonesians have been using delaying tactics. The Dutch are adamant on single control of foreign trade and exchange for the whole area, (i.e. the Republic of N.E.I. and newly formed states). They consider the Republicans technically incapable of carrying out a separate system of external economic relations which they wish to set up. In any case the Dutch want an integrated system within the economic framework of the Dutch Empire. Meanwhile they cannot obtain estate products from the interior or begin reconstruction on estates. Their imports into the area are roughly twice the value of their exports. In the conversation referred to, Hirschfeld said that the Dutch are rapidly exhausting their foreign exchange in the maintenance of their forces and cannot afford waiting much longer.
This confirms the conclusion arrived at by Richardson when here.
 The Indonesians refuse to conclude economic agreement covering trade, foreign exchange, food control and return of estate owners, until the Dutch reduce forces. Sjahrir in our talk with him on Saturday said that a compromise on economic questions was impossible for the Indonesians before the Dutch forces were reduced, as they would have no guarantee of fulfilment of agreements by the Dutch, while the latter possessed the means of using force. The talks between Van Mook, Hoogstraten, Sjahrir and Gani on Saturday morning reached no conclusion on economic issues.
3. Political. The root of the difficulties is profound mutual distrust. We have repeatedly noticed this in our discussions with each side. The cracks which were papered over at Linggadjati are now wider than ever. The economic and military aspects have been dealt with in paragraphs 1 and 2 above. Even less progress has been made on the question of foreign representation, the Indonesians seeking independent Republican representation abroad for all matters concerning the Republic and cooperation only on questions of common concern, the Dutch insisting on inclusion of Indonesians in their foreign service. As for the new states of East Indonesia and West Borneo, the Sundanese move for a state in West Java, and projected state of East Borneo, the Indonesians say that failure to consult the Republic is a breach of Linggadjati.
They regard these entities as puppet states designed to whittle down the area of Republican influence and not conceived in the spirit of the Linggadjati. They are confident that Soekarno's influence will easily preserve Republic control in West Java, and he is at present touring the area.
The Dutch clearly have an interest in any. such division in Java as evidence of political disunity amongst the Indonesians and thus tending to support doubts abroad as to their capacity to construct a workable state. The United Kingdom Representatives here gathered from high Dutch officials tha[t] they believe that world opinion might accept a fait accompli; the Dutch say that a military solution would be achieved very quickly. They are endeavouring to persuade the United Kingdom that such a solution would be in its interests since resumption of N.E.I. trade would enable the United Kingdom to use large United Kingdom holdings in Guilders and exports especially to the United States would strengthen the sterling area generally. They also assert that the alternative of Dutch withdrawal from Java would result in chaos and an increase of Communist influence which they say is already important. The best informed United Kingdom officials here do not accept statements concerning Communist influence. We consider the economic argument is also hollow, as military 'solution' would result in endemic disturbance and guerilla warfare during which little active production could be carried on. It is also likely that the present stocks would be destroyed before the Dutch could recover them. Sjahrir's record and personality suggest that while averse from violence he would be a dogged fighter and confidence the Indonesians clearly have in him suggests that he would be a rallying factor in a prolonged war of resistance. The Dutch seem to us to be quite blind to the fervour of the Indonesian nationalists, perseverance and strength of will of the people sympathetic for independence. This obtuseness is one of the major elements of danger.
4. Van Mook appears at the moment to be interested in it as a peaceful solution. He has been warned that he is to be replaced by Van Meynen, ex-Minister for War, but we understand that he is not anxious to go, at any rate without some positive achievement to his credit. His proposed visit to the United States has been cancelled.  He is now making a last minute bid for a political solution along the lines of an interim Federal Government. Gani told us of this approach which was discussed on Saturday morning.
Van Mook is now engaged on a draft. If he achieved agreement with the Indonesians on this there might be hope of a solution of economic and other issues. Failing this, we are of the opinion that an armed clash on a large scale in the very near future will probably be unavoidable unless some initiative were taken by interested powers. We have heard nothing to suggest that recourse to Article 17 (2) of Linggadjati (Arbitration) is being considered before resort to force. We will endeavour to keep you informed of progress of proposal for an interim Federal Government.