Sanctions, Sanctions-Busting, and the Limits of Incrementalism (updated)

In the years since Treasury dropped the hammer on Banco Delta Asia, North Korea has adapted to make itself less vulnerable to sanctions. It has decentralized its currency flows to different banks to make it harder for Treasury to cut just one weak link. This means that achieving the same effect we achieved in 2005 will take more time today, although – and this is really just an educated guess – a determined attack on North Korea’s access to hard currency could bring the regime to the brink of collapse within two years. I base this guess on the fact that Kim Jong Il approached our diplomats and asked for a deal about a year after Banco Delta Asia, and the fact that Iran did the same about three years after Congress passed its first really tough Iran sanctions bill in 2010, sanctions that brought Iran’s much more diverse economy to the brink.

The main point, however, is that North Korea reacts to incremental financial pressure by adapting and evading, thus blunting the effectiveness of any incremental strategy. Bruce Klingner of the Heritage Foundation makes that argument in a must-read article arguing for the abandonment of the incremental approach in favor of one that shocks the North’s economic system and denies it the time to adapt. I won’t even try to summarize it – just read it. It will add greatly to your understanding of the different items on our sanctions menu, and the different ways they work.

As if to emphasize Klingner’s point, Yonhap reports that North Korea is turning to the Chinese yuan to avoid sanctions, although the report offers little evidence or detail to support this cause-and-effect (the original is paywalled, but the full article is preserved here). It’s possible that this isn’t really news at all. North Korean market traders, private businesses, and ordinary citizens had been turning to the yuan since the Great Confiscation of 2009, a disastrous “revaluation” of North Korean currency that made it virtually worthless overnight. Yonhap could be confusing regime-connected private traders with the regime’s own purchasing agents. It’s also possible that the line between the two is blurring as the relative economic influence of private markets rises. So for reasons that have little to do with sanctions and everything to do with North Korean monetary policy, the yuan is taking over North Korea’s economy.

The real story here may well be the ongoing collapse of the North Korean won, the development of a multi-tiered economy, and a modern-day experiment with Gresham’s Law. The regime still pays official salaries in won, but is being forced to raise wages dramatically to keep up with inflation. The effect may be to send the won into an inflationary death-spiral. Indeed, one of the reasons why Kaesong is such a ripoff for its investors is that the official exchange rate North Korea charges the South Korean manufacturers is, to borrow Marcus Noland’s term, “confiscatory.” The official exchange rate is now so distant from the economic realities of North Korea that the regime can barely enforce it today, even in areas of Pyongyang accessible to foreigners.

(That last link, by the way, is another must-read, via Reuters’s James Pearson. I’ve come to appreciate reporters who try to peek behind the curtain and bring us some useful information. Interestingly, Pearson reports that even in Pyongyang, the dollar is widely used – even preferred to North Korea’s own currency.)

For Kim Jong Un, shifting to the yuan could work as a temporary survival strategy if the North can ride out the storm until it can fool John Kerry into lifting sanctions. That strategy worked in 2007 and might work again, especially if Treasury’s enforcement is half-hearted. And so far, it has been.

The strategy also has limits, and to understand why, you have to understand the difference between two specific types of financial sanctions. The first, we’ll call blocking sanctions. When a target is blocked, any funds moving to or from the target through the dollar-clearing banks in New York do not pass “go” and stay in New York.With the blocking of the Foreign Trade Bank and Daedong Credit Bank, most North Korean banks are now blocked by Treasury. Anyone can see the obvious way around this – the North can denominate its transactions in other currencies (the Euro, which has some standing as a global reserve currency, is the real threat here, not the yuan). The second, I’ll call “blacklisting” sanctions. These sanctions isolate the target by threatening to blacklist any banks, entities, or persons that help the target make, move, or store money. Banks, in particular, will shun any target involved in shady activities if that business could cost them their access to New York. Blacklisting sanctions are the kind that isolated North Korea from the global financial system for the period between September 2005 and February 2007. [1]

(This is not a complete list, of course; I did not discuss other options like divestment sanctions; more traditional options like bilateral trade, travel, and shipping sanctions; or the use of the money laundering and asset forfeiture authorities in the Criminal Code.)

The first problem with North Korea’s yuan-based strategy is that it would be difficult to convert the billions of dollars it has in European and Chinese banks into yuan quickly, and without drawing unwanted attention from the Treasury Department. Invariably, a lot of Kim Jong Un’s dollars will end up stranded offshore. (Recall that North Korea laundered its money through Banco Delta Asia in dollars.) Of course, the more time passes, the more money can escape, but to where? It will still end up in other foreign banks, because the things Kim Jong Un wants to buy with that money aren’t available in North Korea – they’re in China and Europe, and North Korean banks are too heavily sanctioned to be convenient places to store that value.

The greater weakness in the North’s strategy is that it’s no defense against blacklisting sanctions – which the Administration appears unwilling to use. If Treasury offers “credible information” that North Korea is using yuan- or Euro-denominated transactions to launder money, Treasury can still apply Section 311 of the Patriot Act to those banks, provided those banks continue to require access to the U.S. financial system. (H.R. 1771 would expand that authority to provide for the blacklisting of foreign banks that help North Korea evade sanctions, launder money, facilitate censorship or human rights violations, or transact in the proceeds of kleptocracy, similar to existing sanctions against Iran, Burma, and Belarus.)

Update: Yonhap thinks North Korea’s recent outreach to other nations in the region is also part of an effort to evade sanctions. It doesn’t name the countries (OK, maybe it does in the paywalled part [2]) but I will: Mongolia, Indonesia, Singapore, Malaysia, and (probably still) Macau. Blacklisting sanctions can quickly sever these relationships, of course, if Kim Jong Un’s own behavior doesn’t do that first. Consider: he’s never met a foreign head of state or journalist, but he’s now met Dennis Rodman twice. On his way out, the Mongolian President didn’t exactly say what the North Koreans would have wanted him to say:

Mongolian President Tsakhiagiin Elbegdorj, at the end of his rare visit to North Korea late last month, encouraged the North to let its people “live free” and emulate Mongolia’s model of transformation, saying, “No tyranny lasts forever,” according to a transcript of Elbegdorj’s speech on Friday. [Yonhap]

I’ve never put much stock in the idea that interpersonal relations between leaders can bring states with divergent interests together, but having an asshole for a head of state certainly can handicap the state’s diplomacy, and its pursuit of the interests it means to advance through diplomacy. Just ask anyone who’s met Vladimir Putin.

Separately, the Daily NK reports that Jang Song Thaek and O Kuk Ryol have been put in charge of raising hard currency from abroad. They think this is a sign that Jang and O have lost stature and “place” to Kim Jong Un. I am now convinced that Jong Un is in charge — the Rodman visits are gestures of such supreme, self-destructive stupidity that only an impulsive adolescent would have permitted them — but it’s also possible that putting North Korea’s most feared technocrats in charge of foreign currency signals financial desperation.

Overall, I’m less confident today than I was in May that sanctions are working. The effort to isolate North Korea financially clearly lacks the steady attention of the administration and the consequent momentum, trade data suggest only a slight decline in imports, and North Korea’s recalcitrance on Kaesong suggests that its own desperation has waned since then. These are trends I’ll be watching carefully.

[1] Banco Delta Asia continues to operate in a much-reduced state, by doing business in Macanese Petacas, yuan, and other currencies. Its access to the dollar was never restored after Treasury published its final rule in 2007.

[2] Have you seen the cost of a Yonhap subscription? It’s beyond ridiculous.