Asia Economy

North Korea's economy pivots and grows under international sanctions

North Korean leader Kim Jong Un attends a session of the Supreme People's Assembly, the country's parliament, in Pyongyang on April 9, 2014.
Kyodo | AP

As South Korea remains gripped by a gruesome ferry disaster, neighboring North Korea hasn't been lacking in developments.

A new report on North Korea's economy reveals how free-enterprise activities—including the production and distribution of counterfeit goods—are growing and decentralizing beyond the capital city of Pyongyang. President Barack Obama wrapped up his four-country tour of Asia this week. And the U.S. and other allies are considering new sanctions as North Korea threatens nuclear weapons testing. Obama said it may be time to consider sanctions with "even more bite."

But the North's developing economy suggests sanctions intended to isolate the country aren't effective enough—and may be creating an unintended, reverse outcome. North Koreans and Chinese have responded to restrictions with more sophisticated, market-based activities.

State trading firms continue to generate cash. And the regime tolerates open markets throughout the country, where goods and services are traded using the Chinese yuan. Other currencies like the dollar and euro also are circulated.

Sanctions particularly are aimed at muzzling the North Korean elite. But the communist country's 1 percent is far from secluded. People are busy amassing wealth through free-enterprise activities.

"The irony of the markets in North Korea is that a number of those individuals apparently making fortunes, either directly or by accepting bribes, are also senior government leaders and their children," said Bruce Bennett, senior defense analyst at the RAND Corp., a nonprofit research group.

Sanctions, of course, have impeded some market growth. But not enough to force the regime to negotiate and denuclearize. North Korea faces various sanctions from the U.S. and United Nations; and they include an embargo on the import and export of nuclear and missile technology, a ban on all arms exports and unilateral sanctions.

But "North Korea's major trading partner is China, and China has been reluctant to fully impose the sanctions," Bennett said. "Most of the sanctions have thus had only modest effects on North Korea."

Recent months have been relatively quiet after the regime in December executed North Korean leader Kim Jong Un's uncle. The relative, Jang Song Thaek, was a powerful figure. "Jang was like a prince maker," John Park, northeast Asia security specialist at the Harvard Kennedy School, told in December.

Read MoreBeing a North Korea 1 percenter just got dangerous

"I have seen some reports suggesting that Kim Jong Un's uncle Jang had put away perhaps $1 billion in ill-gotten gains," Bennett said.

And even North Korea's 99 percent, well outside Pyongyang, is dabbling in capitalism.

"What we seem to be seeing is that some of the operators in charge of illicit activities in North Korea are not controlled as tightly as they used to be," said Greg Scarlatoiu, executive director of the Washington, D.C.-based Committee for Human Rights in North Korea.

Read MoreInside North Korea's not so isolated, free-enterprise economy

For example, "drug production and trade used to be the exclusive monopoly of the regime," said Scarlatoiu, who leads the nongovernmental group of foreign policy and human rights experts. "We're finding in recent years that this type of activity has been somewhat diversified and more people are involved."

What sets North Korea apart

Counterfeits driving North Korean economy: Report
Counterfeits driving North Korean economy: Report

Communist nations turning to the manufacturing of both illicit and licit goods to raise cash is not new. But leave it to the resilient North Korean regime to reimagine such activities by committing government assets to those endeavors.

For example, North Korea has been counterfeiting Marlboro cigarettes for years, and more recently Viagra pills. "What that suggests is state assets have been involved in the production of counterfeit Marlboros, in the production of counterfeit Viagra or counterfeit currency," said Scarlatoiu. "The presence of state assets is what makes this North Korean activity stand out, compared to similar illicit products made elsewhere," he said.

Based on extensive interviews with North Korean defectors, a recent report—"Illicit: North Korea's Evolving Operations to Earn Hard Currency"—offers an analysis of how expanding economic forces are supporting the regime's self-preservation. The report, released last week in Washington, D.C., was authored by Sheena Greitens, nonresident senior fellow at the Center for East Asia Policy Studies at the Brookings Institution.

The report also reveals how more free-enterprise ventures are decentralizing. And in some cases, those activities are turning criminal, with the emergence of North Korean gangs distributing products beyond its borders.

"The report is about the absence of the rule of law on a grand scale in North Korea and in a way that criminal activity is now being privatized," said Andrew Natsios, co-chairman of the Committee for Human Rights in North Korea.

Drug culture and a 'perverse transformation'

People in Seoul watch television news showing Jang Song-thaek in court before his execution on December 12, 2013.
Woohae Cho | AFP | Getty Images

Glimpses of a free-enterprise economy in North Korea emerged in the 1970s with the trafficking of goods, followed by the production of merchandise beginning around the mid-1990s, according to the report.

A third phase emerged around 2005, when the regime began to reduce its monopoly over some activities. Geographic distribution of goods has expanded to include maritime smuggling routes.

It was around this time, the mid-2000s, that North Korea briefly was involved in manufacturing counterfeit pharmaceuticals.

In the summer of 2004, a South Korean man was arrested in Seoul for selling 4,000 pills of counterfeit Viagra that he claimed to have obtained from North Korea. There were some major discrepancies between the fake and genuine pills. Notably the fake pills were white and round, rather than blue and oval like the originals made by Pfizer. The fake pills were sold for 5,000 Korean won per pill, or roughly $5.

Fake Viagra is part of a decades-long legacy of drug-related activity inside the regime. State-sponsored production of drugs, particularly methamphetamine, appears to have increased in the mid-1990s, according to the report.

North Koreans sell drugs for money. And more people are turning to drugs as cure-alls in the absence of a modern health-care system. Drugs are used to treat chronic diseases and conditions including cancer, malnutrition and hunger, since methamphetamine curbs the appetite.

The new report by Greitens "is very useful in understanding the perverse transformation the country is undergoing," said Natsios, in a prepared statement.

How the regime makes money

A South Korean worker waits to access the Kaesong joint industrial complex in North Korea.
Getty Images

Illicit activities such as drug production and trade are among eight key sources of hard currency for the regime, according to the report. Hard currency is important because it's used to support North Korea's development of long-range ballistic missiles.

The sale of arms and exports generates the largest share of hard currency for the regime, said Scarlatoiu. Other sources of hard currency include the Kaesong Industrial Complex, located north of the demilitarized zone that separates the two countries. The complex accounted for all of inter-Korean trade in 2012, a total of $1.97 billion, according to the report.

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Trade with China, by far North Korea's largest trading partner, is another key area of income. Other sources include tourism and the export of North Korean labor. Most contract workers' earnings are pocketed by the regime.

Remittances sent to North Korea by escapees, and North Korea's nascent mobile infrastructure also raise funds.

Remittances sent into North Korea—through China—are rising as more North Korean defectors assimilate in South Korea. With about 27,000 defectors living in the South, remittances have totaled more than $11 million annually in recent years, according to recent data.

Technology also is generating hard currency for the North. Originally only available to the privileged, cellphone availability is spreading, according to Greitens' report. The regime earned between $400 million and $600 million last year by importing cellphones and selling them at a markup, according to the U.S.-Korea Institute. The government also makes money from its stake in local telecom carrier Koryolink, a joint venture between an Egypt-based media company and North Korea.

What's next? Foreign investment

North Korea's growing threats and China
North Korea's growing threats and China

Despite the development of free enterprise, North Korea's per capita gross domestic product in 2010 still was about $1,800, on par with Ghana's, according to the CIA Factbook. In contrast, South Korean per capita GDP has soared from about $1,200 in the early 1960s to more than $22,000.

For now it's unclear if North Korea's growing market economy will topple the regime. And therein lies the balancing act—taking advantage of economic activities to generate money, without losing a grip on power.

The North Korean government remains fixated on supporting its young ruler, who has little political and military experience, but a strong appetite for socializing with Dennis Rodman. Kim is North Korea's third ruler, and the regime has accomplished two hereditary transitions. The past six decades reads like a movie script, except it's all real—including growing market mechanisms.

North Korea, in fact, has loftier ambitions. It may push for foreign investment, Korea experts Marcus Noland and Stephan Haggard have suggested on their blog. Investment possibilities include mining and herbal medicine.

Read MoreWhy China wants North Korea's rare earth minerals

From the outside, anything resembling reform appears incremental. But if growing market forces are any indication, North Korea is transforming. Business and political circles are overlapping to create a new power structure. In other words, rank and influence aren't simply determined by an old-fashioned social classification system.

Another powerful, Western equalizing force is emerging. Money, and the influence that wealth buys.

Despite international sanctions, the western side of North Korea bordering China is an active, porous supply chain for goods and outside information. "The markets are generating wealth," said Scarlatoiu of the human rights committee. "Sooner or later, the markets will post a challenge to the regime."

By CNBC's Heesun Wee. Follow her on Twitter @heesunwee, and Facebook.