Is there another international conflict on America's horizon? Tension is steadily mounting between the United States and China over trade issues. The U.S. trade deficit with China accounted for almost one-third the record $765 billion U.S. trade deficit in 2006. Both sides agree that this large imbalance is unsustainable, but negotiations to reduce it are making little progress -- putting pressure on the negotiators in Washington at this week's Strategic Economic Dialogue meetings. If not managed properly, the trade imbalance could escalate into a trade war.

  But is this conflict really necessary? The U.S. economy is healthy, close to full employment and flexible. Over time, the U.S. will likely "grow out of the problem" of trade deficits with China, as former Fed Chairman Alan Greenspan put it. As China's industrialization matures, its citizens will grow richer and domestic consumption will rise, thus enabling the country to achieve better balanced growth.

  Still, some in Washington complain that the trade deficit has led to an unsustainable scenario where U.S. net debt now totals 20% of total GDP -- a heavy interest burden. Large U.S. national debts financed by foreign central banks also increase the vulnerability of U.S. financial markets, as the money could be pulled out of the U.S. market at any time. In addition, many politicians have called for protectionist measures in the wake of the loss of three million U.S. manufacturing jobs since 2001.

  China's policy makers have worries, too. The country's rapidly increasing foreign exchange reserves -- a result of its sustained large trade surplus and its open-market interventions to stabilize its exchange rate -- have drastically increased the domestic money supply, leading to inflationary pressure and asset-market bubbles. In addition, the fast accumulation of Chinese foreign-exchange reserves has fueled speculation that China might eventually give in to the pressure and allow for a faster appreciation of the renminbi against the U.S. dollar. The ensuing speculative investment increases the cost for open-market intervention by the Chinese central bank.

  The good news, as Mr. Greenspan and U.S. Treasury Secretary Henry Paulson have pointed out, is that the current trade imbalance is likely short-lived for both countries. Therefore, the real policy challenge is to find the most efficient solution to the bilateral trade imbalance in the short term. The solution provided by U.S. policy makers is to focus on the U.S. dollar-renminbi exchange rate. The Bush administration and Congress are pressing China to appreciate the renminbi rapidly relative to the U.S. dollar. We think this is at best a suboptimal solution, with three major flaws.

  First, this solution is not mutually agreeable and therefore unenforceable. A sharp appreciation of the renminbi would endanger China's export-dependent economy. The mainland is undergoing rapid industrialization to absorb over 300 million rural laborers into the industrial sector. An interruption to that process could cause considerable social instability in China -- something the leaders in Beijing want to avoid. If the U.S. pushes too hard, it could lead to a trade war.

  On the surface, a trade war would damage the U.S. less than China: In 2006, the U.S. imported $288 billion of goods from China and only exported $55 billion. However, the collateral damage of the trade war would include foreign direct investment (FDI). While Chinese FDI in the U.S. is quite small, U.S. FDI in China is substantial and constitutes an important channel for American firms selling in China. Equally serious, a trade war might severely disrupt the flow of Chinese trade-surplus funds into U.S. financial markets, particularly government bond markets. Such flow has in recent years been instrumental in propping up U.S. Treasury bond markets, especially as the low returns on U.S. government bonds make them less attractive to private sector investors.

  Secondly, this solution fails to recognize the fact that the trade imbalance between the two countries is a multilateral, not a bilateral, issue. China serves as the final assembly point for a significant portion of the U.S.-bound exports of other Asian economies. In fact, China runs a substantial trade deficit with its Asian neighbors, suggesting that countries like Japan and Korea are using China to assemble goods, then export them to the U.S. China's trade surplus with the U.S. actually represents the trade surplus of the region -- a fact that undermines renminbi appreciation alone as a remedy for the trade imbalance. A unilateral appreciation of the renminbi would likely shift Asian countries' assembly plants to other low-cost Asian countries, not back to America.

  Last but not least, this solution may create huge risks for U.S. financial markets. It is widely believed that a unilateral appreciation of renminbi against the dollar would not correct the U.S. trade deficit, given that China's deficit accounted for $233 billion as of the end of last year. For the exchange-rate adjustment to be effective in resolving the U.S. trade deficit, a substantial dollar depreciation would be necessary. Such a move might trigger a massive exodus of foreign central bank reserve assets from the U.S. treasury market, sharply reducing the demand for U.S. treasury securities and increasing U.S. interest rates -- at a huge cost to the U.S. economy and crucial elements in it, such as the housing market.

  We think the fundamental problem of the exchange-rate focused solution is that it addresses the terms of trade, rather than trade itself. If both the U.S. and China move one step back and focus their negotiation on trade rather than exchange rates, they may find ample room to restore the trade balance amicably.

  Specifically, the U.S. may consider loosening restrictions on technology exports to China, where U.S. companies are losing out to their Japanese and European competitors. The U.S. harbors reasonable concerns about limiting military-use technology exports to China, but there are vast areas of nonmilitary use technology exports -- particularly environmental protection and energy-efficiency technologies -- that China desperately needs.

  For its part, China might consider levying environmental and energy taxation on its exports, to properly account for the burden of the export sector to the environment and energy consumption. This is in fact consistent with China's domestic policy to maintain sustainable economic growth.

  China could also actively invest its newly generated trade surplus directly in the U.S. in the form of FDI, since this prevents the trade surplus from entering China's financial markets and fueling the oversupply of domestic liquidity. It also helps create jobs in the U.S., and yields a potentially higher return than an investment in U.S. Treasury securities. Such direct investment would be welcomed by the U.S. In 2005, FDI in the U.S. created jobs for over five million American workers and provided 4.5% of all private-sector jobs.

  Of course, China should still take more action on its exchange rate even though it is not at the core of our proposed solution for the trade imbalance. China should allow for reasonably faster appreciation of its currency to the extent that the Chinese economy can tolerate it. This could not only help further reduce the bilateral trade deficit, but also help decouple the renminbi from the U.S. dollar's exchange rate -- giving China more independence in managing its domestic monetary policy, while giving the U.S. flexibility, too.

  China aspires to be the world's leading manufacturing center, while the U.S. wants to maintain its leadership position in R&D and financial markets. As such, the two economies are complementary rather than competitive, at least in the foreseeable future. Instead of short-sighted posturing, cautious policies on both sides should be able to sustain growth and enhance cooperation. Confrontation is in no one's interest.

Mr. Jin is assistant professor of finance at the Harvard Business School. Mr. Li is vice chairman of China Overseas-Educated Scholars Development Foundation and former CEO of Bank of China International.