The “North Korea question” is high on the agenda at Friday’s summit meeting between presidents Donald Trump and Xi Jinping. Speaking outside the White House on Wednesday, Trump escalated the issue, labelling North Korea a “big problem,” calling Kim Jong-un “somebody that is not doing the right thing,” and declaring that he takes full responsibility for solving it. Trump has already had to abandon several election promises upon which he had staked slices of his reputation, and in all likelihood he would get away with abandoning this one, too. Nevertheless, his comments set the scene for a combative tête-à-tête in Florida.

Given that military action against North Korea would be ruinous for all concerned, one of the more plausible threats on Washington’s table of options at Mar-a-Lago is heightened financial sanctions against North Korean entities and/or the Chinese ones that do business with them. It is pertinent, therefore, to ask at this point not only whether such financial sanctions work — which obviously depends on the intended goal — but also what the unintended consequences of their implementation could be.

Wading into the financial sanctions swamp with a new article for Sino-NK, Kevin Gray brings us the findings from his new paper with Lee Jong-woon of Far East University, in which the authors do exactly that: interrogate the usefulness of financial sanctions, and highlight ways in which they have impacted economic development.– Christopher Green, Co-editor

Falling Short: Financial Sanctions and Sino-North Korean Border Trade

by Kevin Gray

While North Korea remains one of the most heavily sanctioned states in the world today, the failure of those sanctions to exert any significant pressure on the regime would not come as a surprise to many sanctions specialists. The academic literature on sanctions has for the most part been rather sceptical as to the efficacy of such measures in achieving their stated objectives. The historical record suggests that sanctions often work to strengthen rather than weaken the legitimacy of the target state through, for example, creating a “rally around the flag” effect and allowing incumbent leaders to place blame for economic hardships on hostile external forces rather than their own economic mismanagement. Furthermore, states and private actors can facilitate the evasion of sanctions through engaging in smuggling and other illicit activities as a means of evasion. The failure of so-called “black knight” states to strictly enforce multilateral sanctions can also serve to significantly undermine the efficacy of the latter.

A recent exception to this pessimism regarding sanctions has been the growth in the use of financial sanctions as a weapon of diplomacy. Financial sanctions have been regarded by their proponents as a more effective means of pressuring target states through isolating them from the international financial system, and in doing so, imposing significant economic costs. Financial sanctions work by explicitly proscribing third-party banks from engaging in dealings with target state entities. If banks fail to adhere to such proscriptions, they face the possibility of being labelled by the US Treasury Department as a “money laundering concern” and, as a result, being shut out of the dollar-based international financial system. Thus, in contrast to “black knight” states that only partially enforce multilateral sanctions or actively facilitate their evasion, the risk aversion that third party banks have means that they are far more likely to cut their ties with target states entities out of self-interest.

A key instance cited in the literature as evidence of the efficacy of such measures has been the US Treasury Department’s action against Macao’s Banco Delta Asia (BDA) in 2005. The US Treasury’s labelling of BDA as a “money laundering concern” led the Macao banking authorities to immediately freeze 52 North Korean accounts at the bank, which led to a run on the bank’s deposits by its other customers. This action alone sent a powerful warning signal to other international banks regarding the risks associated with doing business with North Korea and played a key role in isolating the country from the international banking system.

Financial Sanctions: Hindrance Not Help | Nonetheless, as I have argued in “Cause for optimism? Financial sanctions and the rise of the Sino-North Korean border economy,” a recently co-authored paper with Jong-Woon Lee of Far East University, financial sanctions have in reality done little to exert any broad macroeconomic pressure on the North Korean state. Instead, they have served to encourage the deepening of the informal Sino-North Korean border economy. This is due in part to the combined impact of financial sanctions along with the extensive range of bilateral and multilateral conventional sanctions. Stringent blockades by North Korea’s erstwhile trading partners Japan and South Korea alongside China’s more lax enforcement of UN sanctions have meant that the Sino-North Korean border economy has become central to North Korea’s economic links to the outside world. Furthermore, the geographical specificity of the Sino-North Korean border has enabled informal trade settlement practices to thrive and to play an increasingly central role in North Korea’s external relations more broadly.

Specifically, financial sanctions have undermined attempts made by the Chinese government to establish a cross-border financial system for the purposes of trade settlements. In the early 2000s, the Chinese authorities made numerous efforts to improve the official cross-border financial system. These efforts were partly associated with broader efforts to encourage the use of the Renminbi outside of China and to encourage trade in the country’s underdeveloped border regions. However, they also involved specific measures to integrate the Chinese and North Korean financial systems. In October 2004, for example, the Chinese and North Korean central banks signed the “Agreement on the Settlement of Payment between the People’s Bank of China and the Central Bank of the Democratic People’s Republic of Korea.” Based on this agreement, in April 2005, the representative office of North Korea’s Kwangson Bank in Dandong was permitted to operate exclusive bank accounts that would allow Chinese enterprises and merchants doing business with North Korea to settle trade in Renminbi, US dollars, Euros, Japanese yen or Hong Kong dollars. It thereby became possible to transfer money from China to North Korea to pay for imports, CBP-related fees, and to send investment-related funds to business accounts at a specified North Korean bank in Pyongyang.

However, these attempts have increasingly been undermined by international financial sanctions imposed both on North Korean banks and on foreign banks involved in financial dealings with North Korea. Following the action against BDA, the US has imposed sanctions on North Korean banks directly, which has served to undermine the willingness of Chinese banks to do business with North Korean financial institutions, resulting in the further isolation of North Korean banks from the international banking system. Spurred by their own risk assessments, Chinese banks have increasingly cut ties with North Korean banks.

Weaponizing Greenbacks: Extraordinary Leverage | This reflects the extraordinary leverage that the US has from having its own currency as the world’s reserve currency. Because the dollar accounts for over 85 per cent of the world’s foreign exchange transactions, banks are more or less compelled to make use of a US-based dollar payment system, meaning also that their transactions have to go through a US bank. The US Treasury is thus able to use this structural power to ensure that international banks will stay clear of dealing with North Korean entities. For the most part, any short-term profit to be made through dealings with North Korea are likely to be outweighed by the very considerable risks that are involved.

The “weaponisation of the dollar” that financial sanctions represent has also led North Korea to pre-emptively adopt the use of the Euro as its official trading currency. Yet, this leads to a cumbersome process of wire transfers where dollar payments must first be converted into euros and then converted back again, resulting in excessive fees being charged. As a result, few traders are willing to use such mechanisms.

The impact of these measures has not been, however, to curtail the scope of Sino-North Korea border trade. If anything, the massive growth in that trade over the past decade has coincide precisely with the increased isolation of North Korea from the global financial system. What has happened is that that trade has increasingly been characterised by informal trading practices. This can be seen most clearly in the forms of trade settlement that have been adopted. Typically, the bulk of Sino-North Korean trade is settled in cash, with the remainder conducted via barter. Indeed, trade to the value of hundreds of thousands of dollars can be settled in cash. Interviewed Chinese merchants report, for example, that they would normally receive around 80 percent of payment for their exports in cash with the remaining 20 percent would be paid for with goods from North Korea due to the latter’s shortage of hard currency. These imported goods would typically include mineral resources, seafood, and agricultural products, which are then sold in the domestic Chinese market. As such, a great deal of Sino-North Korean trade goes unreported and often involved the use of informal practices and is sometimes conducted by smuggling networks.

As can be seen, therefore, financial sanctions have not lived up to the hype that they have often received in the academic and policy literature. Rather than serving to undermine North Korea’s external economic relations and put pressure on Pyongyang, financial sanctions have rather driven border trade underground into the realm of the informal economy where it has not just survived but has positively thrived.