Its state-run economy in ruin, North Korea is turning to the kinds of private business activity that it technically considers criminal, allowing commerce driven by private citizens with stashes of foreign currency.

Recent defectors and economists who study North Korea describe an emergent underground capitalism in which ordinary people bring dollars, euros and Chinese yuan into the country and stockpile the currency or spend it at black markets. The money comes from cross-border trade with China or via remittances, payments from defectors sent back home using middlemen.

Some security officials don’t crack down because they, too, need the money; some receive payoffs from traders that outweigh their own salaries, defectors say.

Foreign currency now powers much of the black-market trading, where even state-run companies have become buyers. And because the government sources its own materials from the markets, many of North Korea’s basic state functions would potentially sputter if officials tried to crack down on black-market trading, economists say.

The acceptance of this new model among North Korean authorities marks a tacit admission that the state’s centrally planned economy, which touts self-reliance but lacks the power to provide for its people, is broken.

The North Korean economy was originally designed to operate with strict controls and a heavy dose of central planning. Under that model, the government fed its people, delivering coupons for rations and leaving no need for private enterprise, let alone foreign cash. But when the public distribution system collapsed 20 years ago, leading to a famine that killed an estimated 1 million, the impoverished country encountered a choice between maintaining a broken model or giving space for a new one.

Marriage of markets and currency

For years, North Korea showed fitful tolerance for nascent private-market activity that slowly replaced the ration system. But it also used frequent punishment and policy crackdowns to limit the markets, worried that uncontrolled activity would build a merchant class, at arm’s length from government control, that would learn to take care of itself.

The loosening over the last two years is especially significant, analysts say, because it combines one thing North Korean authorities don’t like (markets) with another thing they wish they didn’t need (foreign cash).

One European diplomat with ties to Pyongyang said the North Korean government “detests” its reliance on foreign money and black markets.

“For a country as fiercely nationalistic as North Korea, this is a major struggle,” said the diplomat, speaking on the condition of anonymity to share frank opinions on conditions within the country.

North Korea faces extra pressure to show its people economic progress, the diplomat said, with new leader Kim Jong Eun taking power after the death of his father.

North Korea realized its dependence on black markets only after a high-profile attempt more than two years ago to eliminate them. That move came through a currency revaluation in late 2009 that effectively confiscated people’s savings. The state said the North Korean currency, the won, was about to become worthless and needed to be swapped for new bills. But when making those swaps, people were entitled to only a fixed amount of new bills, no matter how much they held before.

Black-market activity briefly froze after that. But the revaluation also revealed some of the fundamental flaws in North Korea’s state-run economy, numerous economists say.

“Up to 70 or 80 percent of the entire economy relied on the markets, and within a month of the revaluation, nothing was working,” said Cho Bong-hyun, a research fellow at the Industrial Bank of Korea in Seoul. “Even the state companies were buying raw materials from the markets.”

The rise of foreign cash

It took just months for the government to realize its mistake and allow traders to resume trading. But with that development came a resonant change: a shift from the won to foreign currency.

Because the revaluation ruined confidence in the won, it also sparked sharp inflation, rendering the North Korean currency all but worthless and touching off the drive to collect foreign money.

“Foreign currency has become indispensable,” said Park Hyeong-jung, a senior researcher at the Seoul-based Korea Institute for National Unification, adding that although it used to be common only among senior officials, “now ordinary people, subsistence merchants — they all have it.”

The North Korean government, in its own drive to gather foreign currency — necessary for both business deals with China and the purchase of raw materials from abroad — is pressuring people to give up their cash, offering big incentives when they turn it in.

According to accounts from aid groups, North Korea has, in the past year, opened official kiosks where people can convert Chinese and U.S. currency at the black-market rate, not the predatory official one, walking away with wads of won.

Although foreign currency has long played a crucial role in North Korea’s big business ventures and illicit luxury good purchases, it now drives daily life as well, in an increasingly visible, and quasi-sanctioned, way.

In a recent essay about his trip to Pyongyang, Geoffrey See, managing director of the Choson Exchange group, a Singapore-based nonprofit organization focusing on North Korean economic policy, described a dramatic increase in the number of North Koreans eating at foreign currency restaurants, which once operated almost exclusively for tourists.

The use of foreign money has spread far beyond the capital city and the border areas with China. Within the past year or two, economists in Seoul say, numerous inland cities have opened restaurants — catering to North Koreans — that typically require euros, dollars or yuan.

“The way the economy is working, [everyday] transactions have to be in foreign currency,” said Marcus Noland, a specialist on the North Korean economy at the Peter G. Peterson Institute for International Economics. “It’s an implicit sign of the weakness of North Korean economic institutions.”

As confidence in the won continues to erode, those who have no access to foreign currency face growing difficulties to purchase food. Shortly after the revaluation, a kilo of rice could be bought for 20 won. Now, that same rice costs, in some regions, 4,000 or 5,000 won, twice the monthly wage of a typical North Korean worker.

Foreign money sources

Cross-border trade with China provides much of the foreign currency in North Korea, but economists note a second — and increasingly important — source of such money: defectors in the South.

The 23,000 defectors from the North living in South Korea send as much as $10 million annually, according to estimates, commonly transmitting the money in small bunches, $500 to $1,000 at a time. In North Korea, one such transfer — which typically arrives in yuan — can feed a family for a year, even after it is sliced by handling fees from brokers in China and smugglers in North Korea.

Flush with foreign money, North Koreans can buy corn, rice, televisions and other appliances. Just as important, defectors say, they distribute the money to security officers and ruling party officials.

“You might think the people involved in this are risking their lives, but the security officers are getting money, too; they are depending on these families,” said Ju Kyeong Bae, a defector who said he sends $5,000 to $7,000 annually to his old village, about 25 miles from the Chinese border.

The foreign money also encourages some North Koreans to consider defecting, underscoring one of the primary government concerns about residents holding foreign wealth. Ju knows one such person at the moment. The man works as a border guard, meaning his job is to stop defectors, not become one himself.

“I send money to him, too,” said Ju, whose payments to the guard were meant as a show of friendship. “He gets all of his money from me.”

Special correspondent Yoonjung Seo contributed to this report.