Dec. 6 (Bloomberg) -- Much has been said about the defeat the European Union suffered with Ukraine’s sudden refusal to sign a trade and association agreement. The contrary is true: The EU has had a lucky escape and so have the Ukrainian people.

Ukraine has a dysfunctional economy that faces imminent default. It cannot afford another destabilizing revolution. Rather than make a grand geostrategic choice between East and West, the country needs round-table talks similar to the ones that helped bring about a peaceful end to communism in Poland in 1989. These negotiations should resolve Ukraine’s political logjam and reach agreement on reforms to resuscitate the economy.

The to-do list for Ukraine has been known for a long time: a functioning democracy and a market economy with firm and transparent rules. Yet there has been no political will to take the steps required, because doing so would endanger the vested interests of too many of Ukraine’s political leaders and business leaders. Short of a miracle, Ukraine will continue muddling its way down.

Signing a deep association and trade agreement with a country in such dire political and economic straits was never in the best interests of the EU. The most important reason is that the credibility of Ukraine in fulfilling international agreements is zero. The history of relations between Ukraine and the International Monetary Fund -- still smarting from the $15.4 billion loan it granted in 2010 only to see the government renege on the terms -- demonstrates this all too clearly.

Monetary Transfers

Right now, Ukraine isn’t interested in its own long-term improvement. It wants short-term transfers in monetary or other forms. Its competing elite groups are more in the business of dividing rents than of fostering competitiveness and economic growth. That’s why so many foreign investors have left the country in recent years.

Had Ukraine signed the agreement at the EU summit in Vilnius on Nov. 28, it would have been in a stronger position to demand transfers from the EU, which would have found itself in a corner. Given the current state of the EU’s economy, aid on the scale Ukraine has been demanding -– tens of billions of euros -- isn’t available. The EU would have to choose between subsidizing Ukraine while withholding cash demanded by southern European countries, or leaving Ukraine in a financial hole. Either way, the EU would be divided and under further strain.

A signed agreement would also put the EU’s principles of global governance in question. Ukraine hasn’t even been able to have a serious discussion with the IMF about a policy program, so how could the EU trust it to gradually adopt the more onerous rules and standards of European integration? Such pledges will be credible only after Ukraine has a positive track record with the IMF and the World Trade Organization. In the meantime, the EU has no true interest in the investment it would make through the Vilnius agreements.

President Viktor Yanukovych and his government no doubt acted in their own short-term interests by stepping back at the last moment. The government in Kiev can now continue playing its prospective donors in Brussels and Moscow against each other, and Yanukovych recently added a fundraising trip to China, muddying the picture further. Ukraine needs the money. Official reserves are down to two months’ worth of imports and foreign debt payments are high. A default sometime next year seems inevitable.

As Ukraine’s dominant supplier of natural gas, only Russia has the muscle to force Yanukovych to change policies. Ukraine is heavily dependent on the price of gas, which it uses to produce energy-intensive goods such as fertilizers and metals. In 2012, it consumed 2.3 billion cubic feet of gas. By comparison, Germany, whose gross domestic product is 19 times larger than Ukraine’s, consumed only a little more, 2.9 billion cubic feet.

GDP Growth

The Ukrainian economy’s 5 percent to 6 percent growth rate in the 2000s was largely due to a 50 percent improvement in the terms of trade. Prices for metals and other Ukrainian export goods went up, while Russia continued to provide cheap gas.

Russia faces a quandary, however. Economically, it doesn’t need Ukraine. Depending on one’s assumptions about the size of the shadow economy and the proper exchange rates, Ukraine’s economy is smaller than Finland’s. At the same time, subsidizing Ukraine isn’t cheap and doesn’t guarantee obedience, as Russia’s endless wrangling with Belarus shows. Still, Russia’s leadership believes in geopolitics, and is determined to incorporate Ukraine into the Eurasian Union it is building.

Some in the EU have also adopted a geopolitical approach to Ukraine. This is unfortunate, given that the EU doesn’t have a common foreign and security policy in any serious sense.

The most difficult problem, however, is the one confronting Ukrainians themselves. A political settlement is needed to create consensus around the painful -- and inevitably unpopular -- changes that the IMF and others have itemized: devaluation of the currency, fiscal consolidation, higher prices for domestic energy and structural reforms.

The EU should scale back its ambitions and aim for an agreement on ordinary free trade with Ukraine. The approximation of EU rules and standards -- the element that would make the trade agreement “deep and comprehensive” -- can wait. The EU has grossly overestimated its positive power to transform backward countries. Ukraine saved the EU from a significant mistake. The focus now should be on the country’s economic fundamentals.

(Pekka Sutela is professor at the Lappeenranta University of Technology and former principal adviser for monetary policy and research at the Bank of Finland.)

To contact the writer of this article: Pekka Sutela at pekka.sutela@kolumbus.fi.

To contact the editor responsible for this article: Marc Champion at mchampion7@bloomberg.net.