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Tuesday August 1, 12:36 PM ANALYSIS - China grapples with North Korea's illicit dealings BEIJING (Reuters) - Close as lips and teeth, or a quickly souring friendship? The international community is not sure what to make of China's stance these days toward communist North Korea, a relationship long described by that ancient Chinese proverb. The relationship has come under scrutiny with reports that the state-owned Bank of China has frozen North Korea-related assets at its Macau branch. But analysts say the move probably took place months ago, long before North Korea's July 5 test-firing of several missiles. It was likely motivated by commercial concerns about Bank of China -- and the credibility of its financial sector -- and does not represent a major policy shift in Beijing, they say. "It would be some kind of commercial decision, rather than something grander," said one Western diplomat. Beijing has long sought to prop up its neighbour with donations of food and fuel aid. In talks aimed at dismantling Pyongyang's nuclear ambitions, China prefers carrots over sticks. The United States has slapped financial restrictions against North Korea aimed at halting what Washington says are a web of government-directed illicit activities and last year branded Macau's Banco Delta Asia a conduit for those activities. Washington has refused repeated demands from North Korea to hold direct talks with it over the sanctions, saying Pyongyang can have that kind of discourse in the context of the six-party talks over its nuclear programmes. COUNTERFEIT YUAN? Most analysts played down claims that Beijing froze assets at Bank of China in Macau because it suspected North Korea of printing fake Chinese yuan currency -- an allegation made in a Yonhap news agency report by an opposition South Korean lawmaker. "Although I wouldn't rule it out, there is often an ideological element to counterfeiting that doesn't make as much sense in the Chinese case," said Sheena Chestnut, a graduate student at Oxford University who studies the issue. She cites North Korean defectors as saying the regime justifies counterfeiting of U.S. dollars as a strike against America, thus bolstering its legitimacy domestically. Officials at the media office and the anti-money laundering department at China's central bank, the People's Bank of China, declined to comment on the allegation of yuan counterfeiting. But even if North Korea is not counterfeiting China's currency, analysts say China is still the biggest victim of Pyongyang's illicit activities. Earlier this year, China's central bank warned lenders to be on guard against counterfeit US$100 notes, an irritant China's fragile banking system can ill-afford, and China is a major market for North Korean drugs and fake goods such as cigarettes. But analysts say the Bank of China action in Macau was most likely related to the state-owned bank's stock market listing in Hong Kong in June. With Macau already under scrutiny over the U.S. Treasury Department's probe of Banco Delta Asia -- which it called a "willing pawn" in Pyongyang's corrupt financial activities -- Bank of China's accounts in the Chinese-controlled gambling enclave could not afford to be next. INTEGRITY OF BANKS "China has serious problems in its banking sector, and the Chinese authorities are sensitive about matters that could call into question the integrity of their banks," said Marcus Noland, an expert on North Korea's economy at the Institute for International Economics in Washington. But although Bank of China's action in Macau seems likely to have been motivated by commercial, not political reasons, it is an indication of the diplomatic headaches North Korea has long caused its old ally. Nothing shows its frustration more clearly than China's support for a United Nations resolution imposing weapons-related sanctions on the North in response to its missile tests -- which went ahead despite pressure from Beijing. "When you look at all of the circumstantial evidence, it does seem like China is losing patience with the North," said Peter Beck, Seoul-based director of the International Crisis Group. China hosted North Korean leader Kim Jong-il in January and is the largest source of the country's fuel and food aid -- donations even more crucial since South Korea suspended its food aid in mid-July, until Pyongyang returns to the nuclear talks. But its largesse has yielded few returns, leaving China in a bind over whether to apply more pressure, for example by cutting aid, and risk reaping the fallout on its borders. China, which fought alongside North Korea in the 1950-53 Korean War, fears a catastrophic collapse in North Korea could send refugees flooding across the 1,400 km border they share, and strengthen the U.S. military position in East Asia. "I think the Chinese feel stuck with North Korea," said Beck. "They're frustrated and would like to be able to exert more influence, but they're afraid that they don't have that influence or if they do it could be destabilising to the (North Korean) regime." (Additional reporting by Guo Shipeng in Beijing and John Ruwitch in Kuala Lumpur)