After a first term and a reelection campaign that dwelled on the ills China has caused the U.S. economy, President Barack Obama now must turn to the more difficult business of engaging with China’s new leadership and translating rhetoric into policy. Given the weak economy of the past four years, a preoccupation with harmful Chinese trade practices ahead of the election was understandable. But China is neither enemy nor friend. It is both an economic partner and a security rival.

Beijing views Washington with profound suspicion and does not appear to understand the global impact of the blundering steps it takes outside its own borders. Dealing with this dynamic is an immense challenge for American statecraft. The United States and China are locked in an awkward embrace—on the one hand enmeshed in common economic causes, while on the other hand holding a knife, just in case the ties unravel.

The challenge for U.S. policy is to help bring about fundamental change in both Chinese behavior and in how China sees the world. Altering China's geopolitical and economic calculus is a long-term project. It will require both strategic thinking and military might.

While China needs the United States as an economic partner, it has also been steadily sharpening its knife. The People’s Liberation Army has enjoyed two full decades of double-digit budgetary growth. The result is the most lethal missile force and the most active submarine program in the world. This means it has the capability to project power, keep U.S. forces at bay, and intimidate its neighbors. The United States will need many different classes of ships and submarines to maintain a favorable balance of power in Asia, working together with a preeminent Air Force.

At the same time, the overall economic relationship has considerable benefits: low prices on imported products mean that American families see their paychecks go further, and American businesses prosper by turning China into the world's factory (even if these companies sometimes face competition from their own pirated goods). And American businesses can benefit even more in the future if China continues to grow as an export destination. The U.S. government finds in China a ready buyer of Treasury securities, leading to lower interest rates and a more manageable debt burden (though perhaps also giving a false sense of economic security and allowing a worse fiscal imbalance to build).

A dispute that upended this web of trade and financial ties would have serious negative consequences for both nations. For the United States, this would lead to higher prices for everything made in China—which at times feels like nearly everything—and steeper interest rates on debt for business and government. These negative impacts would be felt by every American. For China, the loss of the United States as a major export market would mean weaker growth and slower job creation, and thus undermine political and social stability. This instability is the ruling party’s nightmare and thus the source of leverage for the United States.

Three Scenarios

China’s future will not look like its past. As China’s export growth model sputters, its calcified political system will struggle to govern a dynamic and energetic population. Dissatisfaction will increase exponentially if the Party does not continue to deliver jobs and growth. Three plausible scenarios can be envisioned.

In a benign scenario, China broadly succeeds in taking on economic and social pressures. The economy shifts over to domestic-driven growth, with China’s three-trillion dollar horde of foreign currency reserves spent to smooth over any hiccups, including necessary financial sector bailouts. As part of the adjustment, China opens up to greater inbound trade and investment, thereby forcing domestic firms to boost their productivity in competition with imports. To maintain strong growth, China will increasingly find it necessary to relax controls on information flows, as the Great Firewall and aggressive censoring of the Internet stand in the way of economic development. Given the dominance and reactionary nature of the Communist Party, it is overly optimistic to expect political transformation to follow close on the heels of economic liberalization. But it may come gradually, since so many Chinese citizens are fighting for more freedom.

For the United States, these changes would mean a China that is more open and fully integrated into the global economic system. With further economic growth and political liberalization, China will be more likely to accept the current liberal global economic and political order, notably including an acceptance of international norms of respect for the rule of law and peaceful resolution of disputes. Chinese military efforts could evolve to promote international stability rather than to project power.

But for this optimistic scenario to play out, China must deal head first with its domestic economic and social challenges. This inevitably will absorb Chinese energies. The great hope in this scenario is that China liberalizes its polity and economy, since these moves likely would alleviate strategic concerns for the United States. Indeed, the U.S. role in this scenario is to provide a supportive global environment for a transition, while guarding against accompanying bouts of aggression.

If China balks at economic and social reforms, the chance of a second and more pessimistic scenario increases. With only a modest change in trajectory from China’s current path, heavy-handed interference in the economy results in the misallocation of resources and financial repression that saps productivity. Economic growth slows further as a labor-scarce China is no longer a low-cost exporter, and the failure to proceed with reforms limits the growth of knowledge-intensive sectors. Without fundamental changes, an economic crisis cannot be ruled out, but in this somewhat pessimistic scenario, growth slows but does not take a deep dive. The Party leadership would look to blame foreigners for dimming prospects and China would shift toward a more aggressive external posture that presents security challenges for the United States. China’s unwillingness to allow tensions with Japan over the Senkaku Islands to simmer down are but a preview of possible Party efforts to rally popular support if the economic situation deteriorates.

In a very pessimistic scenario, the failure to reform leads to an economic crisis. China’s growth falters, posing a political challenge to the Chinese leadership, which then responds with an internal crackdown and an aggressive external posture. The United States then faces regional and perhaps even global challenges as the Chinese leadership embarks on foreign adventurism to distract from domestic failings. A more aggressive China would find itself increasingly distrusted by other nations and excluded from the global economic system. This in turn would affect Chinese growth and further exacerbate external tensions.

The latter two scenarios pose key economic dangers. China and the United States could drift apart in a way that reduces the value of the bilateral economic relationship. Thus, U.S. policy should revolve around how to achieve the first optimistic scenario and avoid the third and most dangerous possibility. Much of the change must take place within China: reforms of monetary and currency policy, removal of trade barriers, and opening the nation to free flows of capital, ideas, and political debates.

On the economic side, the United States should increase national savings to reduce dependence on foreign capital and narrow the trade deficit. This would both provide a market-based impetus to move China away from export-led growth and help avoid populist responses in both countries that could spur a trade war. At the same time, the United States must prepare for the continued political and strategic tensions of the more pessimistic scenarios.

A New Incentive Structure

As China continues to develop, its relationship with the United States will be marked by the contradictory forces of parallel economic cooperation and security rivalry. Consider China’s military modernization, its treatment of its citizens, its intentions with respect to Taiwan, and its troublesome relations with U.S. allies such as Japan and international pariahs such as Iran; together these behaviors demonstrate a deep dissatisfaction with the liberal international order. Chinese policies aimed at upsetting that order are detrimental to U.S. interests. This is the irresponsible side of China. On the other hand, China benefits enormously from its economic engagement with the United States and its participation in the global trade and financial systems. Beijing’s economic incentives for ensuring stability are significant.

The United States should deal with China on separate economic and security tracks. This means continuing to engage China in the economic sphere, even while holding it to high standards in areas such as protection of intellectual property rights and adherence to international treaty obligations. But there should be no illusion that an improved relationship on the economic side will by itself lead Chinese policymakers away from global adventurism.

Instead, the United States must develop tools that will present China with choices and consequences for provocative behavior. Continued Chinese investments in Iranian energy fields, for example, should lead to aggressive financial pressures on the Chinese companies involved, as well as on their bankers, suppliers, and shippers. This will sometimes be uncomfortable for U.S. firms dealing with Chinese businesses, but the China has substantial incentives to avoid allowing security frictions to spill over into the economic relationship. Separating the economic and security tracks means that the United States should seek to maximize the benefits of the bilateral economic relationship. But at the same time, U.S. policymakers should not be afraid to use economic and financial tools as levers to affect Chinese behavior.