Ukraine is at risk of a prolonged recession and may need an extension of its $17bn bailout should tensions with Russia and unrest in the east of the country escalate, the International Monetary Fund (IMF) has warned.

The IMF approved the emergency funding package after Kiev agreed to a sweeping economic reform programme designed to reduce the deficit and promote greater financial stability.

The Washington-based fund expects Ukraine's troubled economy to shrink by 5% in 2014 amid weak investor and consumer confidence, before partially rebounding in 2015 with 2% growth.

However, the IMF conceded there were significant risks to the outlook, not least because of the strong trade and gas ties between Ukraine and Russia.

Announcing the approval of the bailout, which will be released in tranches, the IMF's managing director, Christine Lagarde, outlined the scale of the challenge ahead.

"Deep-seated vulnerabilities – together with political shocks – have led to a major crisis in Ukraine," she said. "The economy is in recession, fiscal balances have deteriorated and the financial sector is under significant stress.

"Risks to the [reform] programme are high. In particular, further escalation of tensions with Russia and unrest in the east of the country pose a substantial risk to the economic outlook."

An IMF staff report published on Thursday stresses that an "unwavering commitment" from Kiev and broad public support are critical to the success of the programme, which includes energy market reforms, spending cuts and tax rises in an attempt to put the economy on a more stable footing.

"A long-lasting disruption of relations with Russia that depresses exports, investment and growth, or a loss of economic control over the east that reduces budget revenue, would require a significant recalibration of the programme and additional financing, including from Ukraine's bilateral partners," it says.

According to the IMF's central forecast scenario, annual growth beyond 2015 should accelerate to 4-4.5% over the medium term.

"There is … a risk that the political, trade, and gas frictions with Russia could lead to strong deterioration in economic relations between the two countries, with a significant drop in Ukraine's exports to and imports from Russia. This would likely lead to deeper and longer recession," the report notes.

Liza Ermolenko and William Jackson, emerging market economists at Capital Economics, said that while the $17bn bailout should ease concerns of an immediate crisis, the picture painted by the IMF appeared too rosy.

"The short-term pain stemming from the programme could well be greater than most expect," they said. "With this all coming against the backdrop of a central government losing control of its eastern provinces, the risk of a messier outcome is still large."

They argued thatthe IMF has tended to give overly optimistic growth forecasts, underplaying the negative impact of reforms on growth. They noted the revisions that were required to Greece's bailout package.

The policies agreed by Kiev include a strategy of gradually increasing retail gas and heating tariffs, by 56% and 40% in 2014, respectively, and by 20-40% in 2015-17.

The IMF said it was a necessary shift after authorities disregarded rising import prices, keeping domestic retail gas and heating prices fixed at the lowest levels in Europe. The IMF said the proportion of household budgets spent on gas and heating spending in Ukraine would rise from 3-7% to 5-11% – "moderate by the standards in the neighbouring countries".

To help bring the deficit down, the government has agreed to restrain the public sector wage bill growth by cancelling discretionary wage increases planned for July and October this year. It will also impose a hiring freeze to reduce employment through "attrition and staff optimisation", while a VAT rate reduction has been reversed.