On July 12, China lost the UNCLOS decision regarding its territorial claims in the South China Sea. These were categorically rejected, as could well have been anticipated years ago. For example, China’s base at Fiery Cross Reef is 630 miles from Hainan Island and nearly at the southern tip of Vietnam. In addition, China’s mooted base at Scarborough Shoal is a mere 150 miles from Manila, while it is 530 miles from China proper. That China would lose this ruling could be foreseen from a very long distance.

Now China faces the question of how to respond.

Beijing has indicated that it will continue with its island building program and reject the ruling by the Permanent Court of Arbitration in the Hague. Over time, this would provide China will increased leverage to institute an air defense identification zone (ADIZ) in the South China Sea. This implies that China would challenge—and by extension, engage with force—any foreign military aircraft or vessel encroaching on this space that fails to identify itself to Chinese authorities. It also implies the material annexation of the South China Sea.

Nevertheless, with the UNCLOS ruling, the United States and other major powers will not honor any China ADIZ in the area. Thus, the declaration of an ADIZ in the South China Sea would be tantamount to a decision to go to war with the United States, and possibly other countries as well. The appeal of this option is rapidly fading, as India and France have also committed to freedom of navigation exercises in the SCS. Does China really want to take on the combined navies of the advanced nations? It hardly seems plausible, and any decent analysis even two years ago would have suggested China would eventually face such an unappetizing option.

China’s South China Sea initiative was misbegotten from the start. China runs a trade surplus of nearly half a trillion dollars with Japan, the EU and the United States, with the United States alone running at a $360 billion annual pace. The U.S. trade surplus by itself amounts to more than 3 percent of China’s GDP. Clearly, starting a war with the United States would see the surplus collapse and throw China into recession.

Further, like it or not, the United States Navy effectively controls both the Strait of Hormuz in the Persian Gulf and the Strait of Malacca near Singapore. Half of China’s daily oil needs pass through these two choke points. In a war, these flows may be subject to embargo, which would bring the Chinese economy to its knees in a month, if historical precedent holds. All these realities were true two years ago as well, and that they were not properly anticipated suggests not only poor policy analysis by the Xi government, but its virtual absence.

So where does China go from here? First, let us acknowledge a few important tenets. China is a Great Power deserving respect. The Chinese people have achieved incredible gains, and that deserves respect, too. China needs a promotion from the rank of Ordinary Powers to Great Power, just as the Chinese leadership and people feel. All of these must be acknowledged. The question is how to achieve them.

For China to back down now in the South China Sea would represent a return to the Century of Humiliation. True, the cause of this is China’s over-reach. The base at Fiery Cross, south of Vietnam’s Ho Chi Minh City (Saigon), was never going to be accepted by the international community, and China was poorly advised to even try. But China’s humiliation is in no one’s interest, and that includes the United States. China is going to be around for a long time, and an angry and frustrated China represents a bad, long-term risk. Even if China loses now, it will try again in ten or twenty years when conditions are more favorable, and meanwhile the Chinese will develop a dislike of foreigners in general and Americans in particular. No one benefits from such a scenario.

On the other hand, declaring an ADIZ and going to war would be destructive to all involved, including China, the United States, and much of the global economy. Humiliation would be far better than outright war, and indeed is looking all the more probable.

Is that it, then? Will it be simple humiliation, with a consortium of foreign powers forcing China to capitulate? Is this an updated version of the United States’ Open Door Policy of the late 1800s, which aimed to keep China open to foreign trading partners? Has China once again started a cycle of serial humiliation?

It seems so. But there is a better path, one which can deliver to China both the respect and hegemony it desires.

At the core of the dispute between the United States and China is the concept of hegemon. Foreign policy can be complex, but the notion is easy enough to understand with a children’s analogy. For China, “hegemon” means that it is now bigger than the other kids in the neighborhood and can take over the playground. In essence, China and the Chinese still think of themselves as an Ordinary Power—just a bigger Vietnam, for example. As just a bigger version of its neighbors, China can leverage its size to get what it wants. It is the first among equals. “We’re big now and we deserve respect, and respect means it’s our playground and you can only play here when we say so. Remember, we can beat you up.”

The United States, by contrast, sees hegemon as “system operator.” In this view, the biggest kid on the block is by definition the adult. The adult has both opportunities and obligations, but these do not include beating up the little kids on the playground and taking their candy. Therefore, the United States sees China in the South China Sea as an irresponsible teenager, preying on weaker countries, rather than living up to its systemic obligations.

The United States is resisting Chinese aggression on this basis, and this is why—contrary to the expectations of the Xi administration—Washington has not folded under Beijing’s pressure in the South China Sea. For the United States, as the system operator—or the world’s policeman, to use the more common phrase—its credibility is at stake in the South China Sea. If it folds there, then United States commitments to dozens of countries around the world come into question, and this in turn invites aggression from disaffected powers like Russia. For China, the issue is limited to the South China Sea. For the United States, it is one theatre in a larger global context.

Thus, if China sees hegemony as “the most powerful country without constraints,” and the United States sees hegemony as “the guarantor of international property rights,” then war or humiliation is the inevitable outcome.

On the other hand, if China behaves as a legitimate system operator, then squeezing out the United States becomes an attainable goal. It would do so by providing hegemonic services to the East Asian community better and cheaper than the United States does. Such services include protecting and assisting in the clarification of regional property rights, as well as the creation of impartial, credible and competent institutions to foster the development of shared resources. It may also imply backstopping the United States to ensure that critical East Asian imports—for example, Saudi and Iranian oil—continues to flow to the region, even if the United States fails to provide security services in the Middle East.

China is well placed to play this role. The country specializes in providing manufactures and services of good quality much cheaper than do the western powers. Playing regional hegemon would simply be an extension of existing commercial strategy to the diplomatic sphere. And China has huge advantages, because an authoritarian regime with ample financial resources can move more quickly and decisively than the protracted and mushy process that characterizes democracy.

Furthermore, China is local in East Asia. The United States is not. Consider that not many people know that the United States actually has two border disputes with Canada. The only way the United States cannot resolve these disputes is with force, even though it could easily defeat Canada in a war. Were the United States to try, Canada would immediately look for allies, and among these would be China. Thus, the United States threat of force would bring China into regional North American disputes. Trust in United States intentions around the world would also be undermined. If the United States is willing to seize Canadian territory by force, what might it do in the Middle East? Might the United States decide to take over, say, Bahrain? The hegemon, in some cases, cannot even threaten force even if it could easily win a fight.

China faces the same logic. If the country threatens it neighbors, as it has, then the United States is sucked into intra-Asian disputes and China’s wider intentions in places like South and East Asia come into question. An aggressive China in the South China Sea paints China as a general threat to the region.

However, if China is providing the public service of policing in East Asia, then the United States will feel comfortable leaving. The voting public in democracies traditionally dislikes spending money on the military in remote parts of the world. They would rather spend it on healthcare and pensions at home. If the United States public feels the country can afford to spend less in Asia—because China is doing a better job than the United States could—then the United States will withdraw. For China, the challenge is not defeating the United States, it is allowing the United States to leave. This is a process of displacement, not confrontation. China allows the United States to withdraw by providing hegemonic services to the region better and cheaper than the United States. It’s that simple.

History tells us that assuming hegemony does not imply war. The United States displaced Great Britain as the global hegemon sometime between the two world wars. Nevertheless, the United States and Britain have been the closest of allies for now two hundred years. Hegemony was passed without conflict, indeed, in some cases at the behest of Britain as the declining power. That is China’s model for East Asia. China becomes influential and respected not because it can beat up the kids on the playground, but because the kids on the playground trust China implicitly to protect personal and property rights and permit fair play. They turn to China for leadership, protection, financial support and organizational guidance. China could be proud of itself for providing these services. That is the true path to hegemony.

I am aware that I am asking a huge amount from China’s leadership and its people. I know many mainland Chinese, even those here in the United States, and they find it hard to adjust to the model I am proposing. Most Chinese still feel small, that they are besieged and are struggling to get to a higher level. They still feel they are competing with Vietnam and Japan. They are thus surprised when I tell them they have already arrived—they have already won the game—they only need to play out the cards they have been dealt to win the match. Doing good will mean doing well, and China will rise to the top, not because it is a military power, but because it is committed to solving problems and dealing fairly with its neighbors.

One could easily imagine a program for China to establish hegemonic services in East Asia. Do this, and China could be running the show in as little as two years. Be that as it may, China must choose. Will it face a humiliating setback in the South China Sea? Will it go to war and risk unmitigated destruction? With the decision to continue to militarize the region even after the UNCLOS decision, we may be on the path to war. But it is not compulsory. China could change tack and adopt a strategy that will bring prosperity and hegemony with integrity and honor. There is a better strategy for China.

Steven Kopits is a President of Princeton Energy Advisors. He consulted to government, state-owned enterprises and private clients in post-socialist Eastern Europe from 1990 to 2005, and monitors developments in China for his firm’s clients. Mr. Kopits regularly contributes commentary for CNBC and writes about oil market for the UAE’s National. He can be reached at [email protected]

Image: U.S. and Chinese flags at China’s CDC. Flickr/CDC Global.