By Robert Kahn
March 14, 2014

FORTUNE — As Russian officials on Thursday announced new military operations in several regions near the Ukrainian border, it becomes clear that the country isn’t just dealing with a political crisis. Its economy is also in jeopardy. The political turmoil we’ve seen over the past two months has exposed Ukraine’s vulnerable economy — a product of years of unsustainable economic polices that include massive energy subsidies and corruption. Addressing these imbalances would have been challenging even in the best of circumstances. With Russia’s military intervention, however, Ukraine has an even tougher job — one that calls for a comprehensive and sustained economic response requiring governments to go outside their comfort zone and learn lessons from past financial crises. If Ukraine is to overcome its crisis, here are three elements international policymakers must address:

1. Fast cash, steady reform

The centerpiece of the Western response must be financial aid and expanded trade. In response to Russian aggressions in Crimea, Western governments, the IMF, and development banks have announced commitments totaling around $20 billion, but most of the money is for financing longer-term projects. While the project financing is critical for long-term growth, much of it would have come in any event; it will do little to address the current crisis. The “real water” — upfront additional funding for the budget — totals around $5 billion, consisting of $1 billion in U.S. government loan guarantees, $3 billion in European Union assistance, and around $1 billion in fast-disbursing World Bank loans. That might be enough to allow the government to provide essential services and restore economic and financial stability between now and the elections scheduled for May. But if past emerging market banking and debt crises are a guide, financing needs are likely to outstrip the current expectations of the official community.

Furthermore, after the change in government, Western governments made the initial mistake of pressing for a quick deal containing major and upfront austerity measures. The EU loans also depended on an IMF deal. This puts the cart before the horse, since it could be some time before Ukraine has a legitimate government in place to make the needed commitments (e.g., raising energy prices and putting fiscal policy on a sustainable track, reforming state enterprises and the energy sector, and addressing corruption), or for there to be sufficient clarity about the economic and political conditions that would allow an IMF program to succeed. Meanwhile, Ukraine’s central bank continues to lose reserves; its banking system is broken, and the government is having trouble providing basic services and collecting taxes.

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A two-stage approach should be embraced, in which short-term financing is disbursed in the coming weeks without additional policy commitments. The IMF should disburse around $1 billion under its emergency rapid financing program ($1.6 billion if the U.S. approves IMF reform legislation). The EU should also accelerate the trade benefits it would receive under its proposed associated agreement, cutting or eliminating customs duties on all Ukrainian products going into the EU and therefore saving Ukraine an estimated $650 million annually. This could plug a critical funding gap through May or June, when hopefully Ukraine’s economy has improved, its economic relations with Russia are at least clarified, and a new government can take responsibility for the program’s tough reforms. That would be the right time for a serious IMF-backed reform effort that would be enacted by the newly elected government.

2. Sanctions could work but it will take time

It is hard for sanctions to be effective. The record is spotty, and many of the cases where they have been perceived as successful in achieving a political or economic agenda — including most recently Iran — were countries whose economies were small, less developed, or less integrated in international markets. To be effective, these sanctions need to cast a wide net — if they are not comprehensive and multilateral, they may be easily evaded.

Although the West was initially hesitant to pursue aggressive sanctions, the Russian decision to proceed with the Crimean referendum has ratcheted up tensions. Chancellor Angela Merkel on Thursday made clear that Germany supports EU action that would follow the U.S. in freezing Russian accounts and imposing travel bans or restrictions on leading Russian figures if Russia did not open meaningful diplomatic talks.

What will make sanctions effective in this case is also a risk. Russia’s business elites have strong ties with the West, and it is reasonable to believe that sanctions against those interests — through visa bans, tighter financial controls, and investment restrictions — can have a meaningful effect. That, in turn, should create conditions for a compromise with Russia. But that greater degree of financial integration also makes retaliation potentially more disruptive. In this scenario, the effects of sanctions could intensify over time, but also become harder to reverse. The creation of “off-ramps” — strategies that allow both parties to step back from confrontation — becomes all the more important.

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3. Avoid a private sector bailout

Should Ukraine restructure its debt? On the surface, debt looks manageable. At just over 40% of GDP, Ukraine’s debt is far less than the levels we see in other countries, such as Greece, Portugal, or Italy. With a strong economic program, many investors believe that market access can be restored quite quickly. From this perspective, there seems little reason to risk damaging debt markets. The IMF and the official community have the resources to finance debt service until market access returns.

I am not convinced though that this is the right course. Debt sustainability will look less certain in a few months, as falling GDP, a depreciating currency, a banking crisis, and a high fiscal deficit inflate the burden of Ukraine’s debt. Regaining market access may be a distant hope. The further challenge of ensuring that the government’s IMF-supported program is adequately financed also argues for breathing space in paying debt. Pushing back maturing debt by a few years and leaving nominal debt unchanged could make a lot of sense in this situation.

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Any debt restructuring should be coupled with pressure on international banks to stay in and maintain their exposure (modeled after the “Vienna initiative” that successfully encouraged banks to remain in Eastern Europe from 2009), coupled with commitments from other private sector investors. I have proposed a “Friends of Ukraine” meeting that would include public and private creditors; others have suggested a private placement of bonds sold to the oligarchs.

More generally, it is not politically or economically sustainable for an official rescue package to finance large private outflows. At some point, a debt restructuring of the external debt looks likely. This approach — though painful for investors in the short run — might give Ukraine the best chance of success and preserve the value of the debt compared to the restructuring that inevitably would follow a failed program.

Robert Kahn is the Steven A. Tananbaum senior fellow for international economics at the Council on Foreign Relations in Washington, D.C. Previously, he was a senior strategist with Moore Capital Management. He also has held positions at the World Bank, IMF, U.S. Treasury, and Federal Reserve.

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