Financial Sanctions on North Korea: Prospects and Challenges in the Age of the Tax Havens

Photo: The Atlantic

On June 1st, the United States Treasury Department proposed new legislation, in conjunction with the North Korea Sanctions and Policy Act, to further estrange North Korea from the international financial system. [1] Specifically, these new measures include a “prohibition on certain U.S. financial institutions opening or maintaining correspondent accounts, which are established to receive deposits from or make payments on behalf of a foreign institution, with North Korean financial institutions. [and] also [a] prohibit[ion] on the use of third parties' U.S. correspondent accounts to process transactions for North Korean financial institutions.” [2] In addition to bolstering sanctions via the Treasury Department, the United States is also cooperating with UN Resolution 2270, which calls for even harsher restrictions on already coercive restriction on finances. Resolution 2270 is only the most recent undertaking that UN has used to show its resolve against the North Korean government. What is unique about the North Korea Sanctions and Policy Act and Resolution 2270 is that both are a part of a new type of sanctions: financial sanctions. Whereas past sanctions have focused on trade, particularly weapons, recent sanctions focus on the bank accounts of both North Korean businesses and leaders. Arguably, this would truly harm the pockets of North Korean leaders. Given the resolve shown by the UN member states and the US, one could imagine that these sanctions would have a strong effect.

However, some months earlier, a massive data leak entitled the Panama Papers revealed the records of a multitude of global heads of states, businessmen, and celebrities whom put their money in the hands of Mossack Fonseca, a law firm in Panama. The leak shows how easily powerful leaders were able to circumvent their respective countries’ tax systems and successfully hide their money for over 30 years. The case of Mossack Fonseca is not new with smaller leaks revealing similar tax havens in Switzerland in 2015 and Luxembourg in 2014 respectively. If anything, the recent release suggests that the use of tax havens is considerably more prevalent than expected. Not only does this issue represent a flaw that affects the finances of individual states, but it also threatens the effectiveness that states have with imposing financial sanctions - an increasingly popular tool to combat unruly states such as North Korea. Since sanctions is the international community’s main weapon, it is important to address which obstacles financial sanctions encounter and whether they provide an effective tool to dictating the behavior of countries like North Korea.

North Korea: Another Case of Failed Sanctions?

Working in conjunction, the United Nations’ member states have utilized sanctions as their tool of choice against Pyongyang. The United Nations passed a multitude of Security Council Resolutions seeking to discourage activities related to nuclear proliferation. Resolution 1718 (2006) and 1874 (2009) banned arms sales to North Korea and required North Korean shipments to be reviewed by UN member states. These sanctions sought to weaken the North Korean weapons sectors, the economy, and their access to crucial knowledge from abroad. [3] Frankly, the sanctions themselves were often met with further resolve by Pyongyang. In response to Resolution 2087, passed on January 2013, North Korea conducted a nuclear test a month later on February 12. The United Nations and Pyongyang effectively find themselves "trading punches" via sanctions and nuclear tests.

Given the lack of success, the sanctions have served as yet another case study of the ineffectiveness of sanctions in altering the actions of other states. Robert Pape, in his seminal work Why Economic Sanctions Do Not Work, evaluates the problems that are inherent with economic sanctions. Three of his arguments that come to mind are the notion that dominant groups often pass down the burden of economic hardships to the least empowered groups in said society; additionally, he contends stronger sanctions do not result in more successful ones. Moreover, enforcement of sanctions are very difficult because not all states comply. [4] The North Korean case serves as an textbook example of these problems.

Firstly, despite the continual work that Pyongyang has done on both its conventional and nuclear weapons programs and its economic growth, poverty has increased in the community. The UN Food and Agriculture Organisation produced a report stating 40% of the population is undernourished, over 2 million mothers and their children are at a high risk of malnutrition, and 75% of the population remain ‘’food insecure. [5] More importantly, larger-scale sanctions have proven not to be successful in the past. In fact, in the seven cases where sanctions lead to economic damage higher than 4.6%, only in the case where Nepal’s GNP decreased by exactly 4.6% did sanctions succeed. On the other hand, the six other cases were categorized as failures; these include the cases of Biafra (1967), Iran (1951), and Rhodesia (1965) where sanctions caused their GNP of the aforementioned nations to drop by more than 10%. Among the issues that are included for the lack of effectiveness is the lax enforcement taken by the participating member states. [6] Overall, sanctions can be categorized at best a bandage merely hiding a larger wound and at worst as counterproductive as demonstrated by the nuclear tests conducted by Pyongyang following the passage of Security Council Resolutions. However, the United States appeared to have a breakthrough with a specific set of sanctions. These sanctions were particularly unique in how quickly Pyongyang responded to them and how they forced the Kim leadership to return to the negotiation table. Unfortunately, this remains a feat that both the United States and the United Nations have been unable to repeat. Nevertheless, they have ushered a new type of sanctions: financial sanctions.

The Importance of Financial Sanctions

In recent years, the sanctions used against Pyongyang have become increasingly complex, and have delved into new territory: financial sanctions. As opposed to sanctions that focus on trade, financial sanctions involve denying foreign officials access to financial holdings abroad. The argument is effectively that heads of states will respond to sanctions that affect their own well-being directly as opposed to sanctions which hurt the populace, a contention made by scholars skeptical of sanctions, such as Pape. Additionally, because the financial sanctions would only impact the leaders of the countries in question, heads of states would arguably have a larger incentive to make concessions. Leaders of non-democratic regimes are not susceptible to elections. Rather, they are more concerned about their survival as their own economic prosperity. If the heads of states are not directly impacted by sanctions, then sanctions have a minuscule effect on their policy making. Moreover, financial sanctions require fewer demands on the hands of the heads of states of UN member states because actions would focus primarily on the financial institutions in their country rather than their entire economy. As opposed to broader sanctions, which can focus on every sector of the economy, financial sanctions focus on the financial institutions inside each country. Theoretically, financial sanctions appear to provide a simpler and more effective version of current economic sanctions.

Furthermore, there is anecdotal evidence that suggests that financial sanctions can work in the right circumstances. Washington utilized financial sanctions when it froze North Korea’s financial assets in Banco Delta Asia, a Macao-based bank holding about $25 million dollars of money from the Kim family. In the midst of a stalled round of the Six Party Talks, Washington banned North Korea access to its money on September 15, 2009. [7] Shortly after, the talks would resume and on September 19th, a joint statement was agreed upon by both parties. The New York Times went on to say that “At almost every meeting aimed at getting the North Koreans to halt their nuclear weapons program, Pyongyang has demanded that the United States lift its penalties against Banco Delta Asia.” [8] Strangely enough, Victor Cha, the then NSC director for Asian affairs, has also stated that a DPRK official admitted to him that Washington had finally discovered a way to truly hurt North Korea. [9] Prior to this, the United States had struggled to find an effective method to negotiate with North Korea. In the past, it used both incentives (the 1994 Agreed Framework) and threats (sanctions and refusal to speak with North Korean diplomats). While the Six Party Talks themselves ended inconsequentially, the immediacy in which Pyongyang responded to Washington suggested that freezing assets might be a powerful tool.

Photo: U.S. Department of State

The UN continued its use of financial sanctions on a larger scale in 2013 with the passage of Resolution 2087. In addition to the arms embargo and trade inspections present in past sanctions, Resolution 2087 froze the assets of North Korean individuals after the December 12, 2013 satellite launch [10]. These sanctions would be further strengthened in response to the Pyongyang conducting a nuclear test in 2013. Resolution 2094 called upon member states to deny financial services to North Korea and warn against smuggling in the area. [11] On March 3rd, the United Nations finally agreed on a comprehensive set of sanctions aimed to punish North Korea following its successful missile test earlier that year. The sanctions seek to abate North Korea's nuclear ambitions by hurting its economy, inconvenience its leaders, and to sap the leadership's access to outside expertise. The measures themselves include a ban of North Korean exports, close monitoring of North Koreans, and a suspension of academic programs that teach North Koreans nationals skills that could further North Korea's nuclear ambitions, and a ban on the purchase of luxury goods to North Korea. [12]

Why the Panama Papers Matter

In spite of the growing scale of financial sanctions, North Korean officials have shown more determination and resolve than they evoked in 2009 when the United States government successfully froze $25 million in assets. This is not particularly surprising given the current climate regarding tax havens such as Panama. While a large number of the Mossack Fonseca clientele utilize tax haven in order to avoid paying taxes, anonymity is a another draw for some states, especially those subject to sanctions, such as North Korea and Iran. [13] Because of the sheer secrecy of the Mossack Fonseca, essentially anyone with a willingness to pay was able to hide their money in the firm, including blacklisted individuals and governments.

Among the people the firm worked with was “33 individuals or companies who have been placed under sanctions by the US Treasury, including companies based in Iran, Zimbabwe and North Korea.” [14] In fact, a guilty North Korean party has already been identified. The Panama Papers leak revealed the involvement of Kim Chol Sam, a North Korean official, and Nigel Cowie, a British businessman, under the auspices of Daebong Credit Bank (DCB) [15]. For 20 years, the bank served as a front for the trading of weapons, withstanding trade as well as financial sanctions. Additionally, the leaks also revealed two Australian businessmen, David Henty Sutton and Louis Schurmann, who were seeking a mining agreement with North Korea under the auspices of a shell company despite the ongoing sanctions. [16]

The Panama Papers serve as another reminder that tax evasion is rampant and that it continues to appeal to those seeking anonymity. Freezing the bank accounts of government officials should be easier given that money is often placed in the hands of trusted large banks. The continuous leaks of the offshore holding suggest that even finding the holdings of government officials is much harder than expected. Aside from the massive tax revenue that tax havens hide from local governments, an issue for another day, the fact that $2 trillion, an amount that rivals the GDP of India, could be hidden in a tax haven for 30 years represents how grave of an issue existing tax havens can be for rogue regimes. Many would consider sanctioning the North Korean economy as a fairly weak method of attacking the regime given that North Korea barely has a legitimate economy at all. Adding a tax haven-savvy North Korea further complicates what initially seemed like a good method to hurt North Korea sans military action. Given the millions of unaccounted dollars that have contributed to North Korea’s conventional and nuclear warfare, the combating of tax havens by the international community is no longer merely an economic issue but also an issue of international security.

The Complex Challenge to Effective Reinforcement

If the international community wants to continue its use of financial sanctions in order to lure Pyongyang back into negotiations, it needs to take sanctions seriously by improving enforcement. Unfortunately, the problems of enforcement are numerous. Namely, there are issues of willingness on the part of all member states to strictly enforce their own sanctions on North Korea. Furthermore, given the entire country’s heavy emphasis on a black market, it is exceeding complicated to target financial transactions of leaders and their foreign co-conspirators, as seen earlier. The black market nature of the North Korean economy also risks hurting local businesses, which have been blooming in recent years and have relied increasingly on cross-border trade with China and Japan. In essence, two of the main issues that harm the prospects of conventional sanctions are also present in financial sanctions: problems of enforcement and the potential to hurt ordinary citizens of the country in question.

Problems of enforcement limited the impact that conventional sanctions have on North Korea. Despite the numerous sanctions placed on it by the international community, the North Korean economy has consistently grown by over 1% for the least three years, anemic growth but impressive given North Korea’s supposed lack of trade partners and rudimentary industries. The black market has been estimated to account for up to 30% of North Korea’s economy. [17] Arguably, North Korea has already discovered multiple loopholes given its long history under sanctions. The United States single-handedly sanctions North Korea and North Korean-related groups 14 times between 1950 and 2004 with actions range on a complete embargo on exports to North Korea to tying negotiations to a change in North Korea’s human rights record. [18]

Photo: Reuters

Much of the growth that has resulted in spite of the sanctions is the result of growing private market activity. Initially subject to harsh penalties and feared by the Kim Jong-Il government, the subsequent Kim Jong-Un regime has indirectly given its reluctant support to private economic activity. As a result, a growing middle class have seen their disposable income grow considerably in recently years, especially those with trade links to China. North Korea has become more lenient about cross-border trips. The very nature of black market activity suggests that the money made and spent by such individuals remains a mystery. Arguably, if sanctions seek to be effective, all contributors to North Korea’s nuclear program and activities should be targets. In fact, sanctions have already targeted some the new entrepreneurial class with connections to China. Whether or it, Jane Perlez of the NY Times reports, “The smaller banks in the northeast area of China that borders North Korea would probably not want to risk continuing to do business with the North because the cost of sanctions by the United States would far outweigh the benefits of such commercial ties ‘’ [19] Despite years of sanctions, China has continuously participated in trade with North Koreans along its Northern border. One does to question whether harming the growing middle class is an effective way to encourage change in North Korea. Considering the widely-held belief that a growing middle class is a key player in democratization, the UN and United States’ actions could be counterproductive.

With UNSCR 1718 and 1874, the United Nations sought to disincentivize North Korea from obtaining a nuclear weapon by weakening its arms trade and indirectly its legitimate trade. Instead, after the first round of sanctions were placed in 2006 (Resolution 1718), China and South Korea, North Korea’s two largest trading partner, actually had more economic integration than before sanctions were put in place. From the beginning of sanctions to July 2008, trade between North Korea did not cease, but grew and North Korea developed a growing trade deficit with China. Similarly, trade between North Korea and South Korea witnessed higher than expected trade volume. Rather than zero, the trade between North Korea and its two largest trading powers were an upward trajectory. [20] It comes as no surprise that North Korea was willing to tolerate the constant sanctions by the United Nations. Semoon Chang, a professor of economics and the director of the Center of Business and Economics at the University of Alabama, contends, “’it appears impossible to impose a complete ban on North Korea’s foreign trade without a naval blockade … there little doubt that a complete ban of North Korea’s foreign trade, if imposed would easily lower the current North Korea’s GNP in the 1999 level, at which hundreds of thousands, if not millions, of North Koreans starved to death.” In reality, in 2004, North Korea engaged in trade, whether in exports or imports, with 108 nations, or over half of the countries in the world. It appears the country known for its praise of self-sufficiency is considerably more cosmopolitan at a second glance. [21]

Prospects and Complications for the Future

With the increasing complexity of financial transactions and the resulting transparency, it is possible that the Kim family could be hording millions, even billions of dollars, in offshore bank accounts akin to Mossack Fonseca. If not taken seriously, financial sanctions may also fall victim to the same fate as past sanctions: merely a feel good action. The world has already witnessed how financial sanctions have been able to bring back North Korea to negotiations, but it can only hope that its first occurrence was not a fluke or part of an unrelated aspect of North Korean decision calculus. Fortunately, some recent developments suggest that proponents of financial sanctions can be optimistic. On May 18th and 19th respectively, Switzerland and Russia announced that they are both taking actions to strengthen sanctions on North Korea. Switzerland has implemented “measures as a freeze on cash and assets related to North Korea nuclear and missile development, the closing of North Korean banks and bank branches operating in the country, and an increased list of luxury items subject to embargoes’’ whereas Russia has instated ‘’measures [that] ban financial transactions with North Korea except in cases approved by the UN.” [22] The support of these two countries is paramount given Switzerland’s fame (or infamy) as a popular tax haven and Russia has been known for being reluctant to participate in the UN. Moreover, Pyongyang has shown interest in joining the Asia Pacific Group on Money Laundering (APG), the Asian regional group representing the Financial Action Task Force on Laundering (FATF). By enacting a law prohibiting money laundering and the financing of terrorism, Pyongyang is trying to make itself look appealing to the group, suggesting that the government wants sanctions to be removed. [23]

Another major issue that arises is whether one should for the success of financial sanctions. While the success of the sanctions remain unlikely given the increasingly complex nature of the flow of money, one has to question if hurting the finances of the growing middle class may outweigh the benefits of freezing Kim Jong-Un’s access to his favorite Swiss luxury goods. Whereas the wealth of the North Korea elite is located both inside North Korea and abroad, the wealth of independent entrepreneurs will be hurt punitively if they have a large stake with trading with China. When sanctions were enacted against North Korea, there were enacted with the purpose of altering Pyongyang’s nuclear weapons programs and its human rights record. Sadly, Pyongyang has not considered these actions to be punitive enough. It may even consider them an unexpected gift if it weakens the growing middle class’ clout. While Kim Jong-Un has supported reforms, he has been cautious to not let the floodgates open too quickly. The sanctions may, in effect, help him in the pursuit of that goal.

It is far too early to quantify how much is expected from these sanctions, given their constant use against North Korea. However, given the novelty of financial sanctions, one can only hope for a breakthrough. Financial sanctions do provide a unique new method of confronting North Korean non-violently without the moral dilemma of starving people who happen to live in a country with an anti-democratic ruler as a way to a means. With some luck and some strong enforcement, how to get North Korea back to the negotiations table might just be another $25 million question.

***The views herein do not necessarily represent the views of North Korean Review, YINKS, or Yonsei University.

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