The end of 2008 could be a momentous time for Sino-American commercial relations. A new U.S. President will take the reins just after the 30th anni­versary of China's market reforms. Natural attention is being given to what the new President plans for the Strategic Economic Dialogue (SED) and other elements of the economic relationship.

But the 30th anniversary marks a more impor­tant development to the future of these negotia­tions. Reform began 30 years ago-about three years ago, it stopped.

Since the present Chinese leadership took power in late 2002, market-oriented reform has been minor, resting on a legacy of earlier decisions. As market-oriented policies wind down, they are increasingly supplanted by state-run development. The last few years have been characterized by price intervention, absence of privatization, rollback of competition, and fresh investment barriers.

By most economic standards, however, the state has done very well. Success has created a constitu­ency, moving Beijing dangerously close to an obses­sion with growth at the expense of all else. It presently does not see a strategy of further genuine market-oriented reform as in its long-term interest. Whatever the objectives of the new U.S. Adminis­tration, it must surmount this frame of mind. While true broad-based market-oriented reform should remain as a goal and context for American eco­nomic policy toward the People's Republic of China, the next Administration's economic diplomacy would do best to focus negotiating objectives on an evaluation of actual Chinese development strategy of rapid and state-led growth. American policies that presume ongoing market reform will be flawed from the start.

One response is to dismiss the whole endeavor of economic engagement with China. That would be a high-stakes gamble. The U.S. and China combined accounted for more than 30 percent of gross domes­tic product (GDP) worldwide last year. Bilateral trade volume between the two countries stood at $387 billion, dwarfing the $208 billion between America and Japan. Chinese exports to the U.S. were the equivalent of approximately 9.5 percent of Chinese GDP in 2007 while its holdings of U.S. treasuries were more than $500 billion at the end of June 2008. This is the most important bilateral eco­nomic relationship in the world. Even incremental improvement in its structure would have a large economic payoff.

With this in mind, the question is how to engage China. The answer depends first on the new Presi­dent's viewpoint on trade. The advantages of free trade are apparent both in the abstract and tangibly. At its core, free trade offers opportunity and choices to businesses and consumers, while protectionism limits both. It would be especially difficult in the current economic environment for a President to move sharply away from open trade: Surprisingly vigorous second-quarter GDP growth this year was driven almost entirely by trade. It is thus quite unlikely that the new President will simply abandon economic dialogue with the People's Republic.

Fortunately, while the substantive ground has shifted, the existing institutional framework for Sino-American economic relations, topped by the SED, is generally sound. Retaining the SED or an equivalent arrangement offers a superior path to progress in bilateral talks, though the location of U.S. negotiating authority should be changed from the Secretary of the Treasury to the Vice President. This makes changes in U.S. policy relatively easy to implement.

Under the circumstances, the best action that the U.S. can take is to encourage the Chinese to move in the right direction by focusing on a narrow range of reform that is feasible in the present context. The changes proposed here feature steps toward long-term price liberalization, curbing state dominance at the corporate level, shielding American compa­nies from mercantilist "reforms," and restarting the process of opening the capital account to allow money to move freely in and out of the country.

Conclusion. Economic dialogue with China may be even more complicated than the next Presi­dent anticipates. The importance and multifaceted nature of the relationship call for an overarching institutional mechanism like the SED. But some present American objectives fly in the face of a state-dominated development model that has yielded rapid growth and is thus deemed very successful by the Chinese government. The recommendations made in this paper take into account Chinese reac­tion and are WTO-compliant. The lead negotiating authority in the SED can thus be assertive in terms of legal or other actions in pursuing these outcomes.

Though only modest progress can reasonably be expected until the flaws of China's model become more apparent, true market-oriented reform must remain the ultimate goal. The next American Administration should, therefore, continue to state the case for deeper liberalization of China's econ­omy. This will emphasize that long-term U.S. objec­tives have not changed and prepare the ground for the time when China is again open to market-ori­ented reform.

Elements of the new Administration will surely offer alternate views to the one argued here. An obvious alternative is to pursue much more funda­mental change on the Chinese side. With President Hu Jintao and Premier Wen Jibao committed to a path that has brought at least 10 percent annual GDP growth since they assumed power, some will maintain that sharp protectionist threats are required to move them toward fundamental change. The problem with such protectionist threats is not that they are not credible, but that they are not effective, and in fact, counterproductive. Protectionism will harm the U.S.-even if it harms China more. Threatening to cut off one U.S. finger while cutting off two of China's fingers amounts to damaging political posturing instead of viable, effective policy. American leadership is demon­strated by the confidence and ability to thrive in competitive environments at home, in global mar­kets, and in the People's Republic of China itself. Protectionism is a retreat from that leadership.

Derek Scissors, Ph.D., is Research Fellow in Asia Economic Policy in the Asian Studies Center at The Heritage Foundation.