(Foreign Affairs) The Pyongyang Playbook

This is a very nice analytical article on North Korea's diplomacy.
The author said, “Based on this trajectory, North Korea will likely conduct another nuclear test in the coming months, tempting the Obama administration -- which has yet to yield to Pyongyang’s playbook -- to start afresh with negotiations early next year. Possible dates for the test include September 8, the eve of North Korea's National Foundation Day, and October 10, Party Founding Day. ” Let's watch out for the DPRK with “strategic patience”!


The Pyongyang Playbook

Sung-Yoon Lee

SUNG-YOON LEE is Adjunct Assistant Professor of International Politics at the Fletcher School of Law and Diplomacy at Tufts University.

One persistent misperception about North Korea is that its provocative international behavior is unpredictable. In the last two years alone, North Korea has held four U.S. citizens hostage; fired a long-range missile over Japan; conducted further nuclear testing; and, most recently, torpedoed the South Korean warship Cheonan, killing 46 sailors on board.

In fact, Pyongyang's methods have been remarkably consistent since the early 1960s, when Kim Il Sung, the nation’s founding dictator and its current leader’s father, purged all potential rivals and consolidated power. Its strategy has been to lash out at its enemies when it perceives them to be weak or distracted, up the ante in the face of international condemnation (while blaming external scapegoats), and then negotiate for concessions in return for an illusory promise of peace. Incapable of competing with economically flourishing South Korea, the North can rely only on military and political brinkmanship to make up ground. This has been a stunningly successful game plan for the isolated, impoverished nation that sits amidst the world’s most powerful status quo states, including China, Japan, Russia, South Korea, and the United States.

North Korea's policy toward the Obama administration has closely followed this time-tested strategy. The United States has a long and undistinguished history of playing into the North’s game plan. However, the Obama administration has deviated from this pattern and adopted a policy that U.S. officials have dubbed “strategic patience.” The White House has attempted to remain calm in the face of North Korean provocations and has resisted making deals with Pyongyang merely for the sake of defusing tension. In view of the North Korean regime’s strategic outlook, it is the right approach.

The North has long chosen to confront its adversaries when they are weak. In 1968, as the political tide was turning against the United States in Vietnam, North Korea dispatched a 31-man commando team to kill South Korean President Park Chung Hee. Although South Korea thwarted the raid, Pyongyang continued its offensive two days later, when its forces captured the U.S. intelligence ship Pueblo in international waters off the coast of the Korean peninsula. One U.S. sailor was killed in the seizure; the remaining 82 crewmembers were held captive under torturous conditions for 11 months until they were released following an apology by the Lyndon Johnson administration.

After enduring international condemnation, North Korea often decides to stay the course and even increase political tensions. During the Pueblo standoff, North Korea carried out commando raids against South Korea, sending more than 120 soldiers that October and additional troops the following year. The South Korean military quelled the raids, but Pyongyang, emboldened by continued U.S. difficulties in Vietnam, soon greeted the new Nixon administration with further violence. On April 15, 1969, on the occasion of Kim Il Sung's birthday, a North Korean jet shot down a U.S. reconnaissance plane, killing all 31 U.S. servicemen aboard.

The United States attempted to manage these crises in the 1960s by responding with conciliatory gestures aimed at alleviating tensions. North Korea learned that it could provoke, and even attack, the world’s greatest military power with impunity.

The North has redeployed this tactic in recent years. In 2006, for example, it attempted to capitalize on U.S. difficulties in Iraq. As Americans were celebrating July 4, North Korea carried out a barrage of missile tests, even firing a long-range missile in the direction of Japan.

This was the prelude to a far more confrontational act: North Korea’s first-ever nuclear test, which occurred on October 9, the eve of the Korean Workers’ Party Founding Day. By demonstrating its nuclear capabilities, North Korea painted the Bush administration into a corner. It also blatantly defied UN Security Council Resolution 1695 -- passed earlier that year in response to the North’s missile tests -- which called on Pyongyang to “abandon all nuclear weapons and existing nuclear programs.”

The October 2006 nuclear test yielded a more strongly worded Security Council resolution (1718), which demanded that North Korea “not conduct any further nuclear test or launch of a ballistic missile” and called upon UN member states to “ensure” that funds supporting North Korea’s nuclear program be cut off. More important, it triggered a change of heart in the George W. Bush administration, which chose to abandon its effective policy of financially squeezing North Korean elites' cash flow and instead negotiate a nuclear agreement with North Korea the following February. In return for Pyongyang’s promise to dismantle its nuclear arsenal, Washington sequentially unfroze North Korea’s illicit funds, resumed food and fuel aid, and delisted North Korea from the U.S. State Department’s list of state sponsors of terrorism.

Leaders in North Korea believe that their aggressive behavior can coax such concessions yet again. Thinking that the Obama administration -- coping with two ongoing wars and a serious economic crisis -- would be quick to opt for diplomacy, Pyongyang launched a long-range missile in April 2009, dominating global headlines and diminishing Obama's then high-profile visit to Europe. Pyongyang assumed that Obama could be bullied into seeking conciliatory diplomacy. Such assumptions, however, have yet to be borne out.

After raising the stakes with its opponents, the North often retreats and demands negotiations. It did this in 1972, when, stunned by U.S.-Chinese rapprochement the previous year, it agreed to hold the first-ever high-level talks with the South since the Korean War. Since then, Pyongyang has intermittently launched “peace offensives” at the United States, hoping to sign a treaty that would lead to the withdrawal of U.S. troops from the South.

Yet Pyongyang often sues for peace while forging ahead with forbidden activity. Even after it entered negotiations with South Korea in 1972, it continued hostilities against its southern neighbor. North Korean agents kidnapped South Korean fishermen and made another attempt on the life of South Korean President Park Chung Hee in 1974, leading to the death of his wife.

In the Kim Jong Il era, North Korea has consistently applied this approach of illusory concessions to the nuclear issue. In the wake of signing the 1994 Agreed Framework -- a deal in which Pyongyang agreed to freeze its plutonium-based nuclear weapons program in exchange for energy aid -- the North sealed its main nuclear reactor and opened doors to International Atomic Energy Agency inspectors. But North Korean leaders quickly flouted the plan. In 2008, Pyongyang drafted an 18,000-page laundry list of nuclear activities while refusing to provide samples from its nuclear complex to outside inspectors on request. Despite its duplicity, North Korea still managed to be removed from the State Department’s terrorism blacklist in October of that year.

In recent weeks, Pyongyang has dangled an olive branch before the Obama administration. Apparently pleased with the weakly worded July 9 UN Security Council presidential statement on the sinking of the Cheonan -- which, despite overwhelming evidence of North Korean culpability, failed to blame the country for the act -- Pyongyang has suggested that it would return to the six-party denuclearization talks. By intimating a willingness to rejoin the multilateral forum, the North is seeking to deflect the negative attention it has received from the Cheonan incident. Once again, the North is presenting an image of reconciliation in the hopes of more political and economic rewards.

While angling for compromise, the North often offers meaningless theatrical gestures. In 2008, it allowed the New York Philharmonic to play in Pyongyang. Later that year, it blew up an old nuclear cooling tower, one that had exhausted its lifespan and could easily be rebuilt. Such dramatic displays are designed to bolster proponents of concessionary diplomacy in the United States and South Korea. They target those who unwittingly take the patronizing view that North Korea, lacking a strategic mindset of its own, merely reacts to positive stimuli -- be they musical overtures or diplomatic civility.

Yet U.S. policymakers should not be deceived. Amidst ongoing talks with Washington this past decade, North Korea has sent nuclear technology to Syria, as revealed in the wake of the Israeli air strike on a North Korean–built nuclear plant, Al Kibar, in eastern Syria in September 2007. In July 2008, North Korean guards killed a South Korean tourist taking a walk along a resort in the North’s eastern coast, a site funded by the South.

Meanwhile, Pyongyang has pressed ahead with drug trafficking, money laundering, and U.S. currency counterfeiting. It has also attempted to export arms in violation of UN resolutions. Last December, for example, a North Korean shipment of rockets and rocket-propelled grenades was seized in Bangkok that, according to Thai officials, was destined for Iran. In a failed plot earlier this year, Pyongyang sent agents posing as defectors into South Korea to assassinate a high-level North Korean defector.

The incitement from Pyongyang is likely to continue. North Korea's artillery barrage on and near the western maritime border with South Korea on August 9 and its seizure, the day before, of a South Korean fishing boat allegedly in North Korea’s eastern exclusive economic zone are just the latest examples of Pyongyang’s predictable game plan.

Based on this trajectory, North Korea will likely conduct another nuclear test in the coming months, tempting the Obama administration -- which has yet to yield to Pyongyang’s playbook -- to start afresh with negotiations early next year. Possible dates for the test include September 8, the eve of North Korea's National Foundation Day, and October 10, Party Founding Day.

Moreover, the political bureau of North Korea’s ruling Communist Party is scheduled to convene a rare meeting in early September where Kim’s heir apparent may be formally introduced. North Korea's intention to implement another father-to-son power transition makes the odds of a nuclear test even more compelling -- if only to bolster the inexperienced inheritor's military credentials. For a nation that professes to pursue “military first” politics, the implementation of another hereditary succession is certain to carry greater legitimacy if it comes on the heels of a dramatic demonstration of military prowess.

The U.S. should maintain its strategic patience with North Korea. It must put sustained pressure on Pyongyang's points of vulnerability -- principally, the cash flow needed to sustain its palace economy. In recent weeks, the Obama administration has repeatedly stated that it would strengthen financial sanctions against the North Korean leadership, targeting its counterfeiting, money laundering, and other illicit activities.

Furthermore, North Korea has shown itself to be sensitive to criticisms of its human rights abuses in the past, categorically denying that it perpetrates human rights violations in its “workers’ paradise.” Thanks to public pressure, the North has reduced its execution rate in recent years while sporadically relaxing prison sentences for border-crossers. Although such changes may be more a function of logistic difficulty than determined policy, the fact that foreign criticisms impel North Korea to cover up its manifold human rights abuses is beyond doubt. The White House should take a firm stand on North Korea's human rights violations, which would not only give hope to the long-suffering North Korean people but also impel, if only incrementally, Pyongyang to relax its crackdown on political prisoners. At the very least, such a principled stance would galvanize international cooperation on reunifying the two Koreas under a democratic government should the North’s regime collapse.

These policies will help the Obama administration avoid getting drawn into a dangerous military conflict with North Korea. Today, the North Korean regime faces the greatest existential threat since the disintegration of the Soviet Union. Beset by a perennial economic crisis, increasing information flow into the country, and the uncertainty of another dynastic succession -- while struggling to rein in an ever-increasing number of North Koreans who wish to escape to the South -- Kim Jong Il must confront serious questions of long-term self-preservation. Amidst all this, Kim, who suffered a stroke two years ago, is himself racing against the clock. A dictator for life, he used to enjoy the advantage of outlasting democratically elected leaders. Strategic patience will best exploit his new limitation.

Time is no longer on Pyongyang’s side. The U.S. should avoid chasing North Korea through a revolving door of provocation and deception, unwittingly subscribing to the tactics presented all too plainly in the decades-old Pyongyang playbook.

My latest story for Asia Times. Japan's new round of musical chairs

I wrote about Ozawa's bid for the DPJ presidency. In my view, Ozawa is Japan's dirty hero, who could cause major political and economic change in the country.

Japan's new round of musical chairs
By Kosuke Takahashi

TOKYO - Around the globe, poor economies are weakening already vulnerable governments and causing political changes. This was so in the United Kingdom in May and is likely to be reflected in the November mid-term elections in the United States.

Japan is no exception. With the country facing a rising yen, sluggish domestic demand and unstoppable deflation - all significant contributing factors to the sinking of the world's long-time second-largest economy, musical chairs with the top job may possibly burden the nation with its third premier in a year.

Political kingpin Ichiro Ozawa, 68, a member of the governing Democratic Party of Japan (DPJ), on August 26 took on Prime Minister Naoto Kan, 63, declaring his candidacy for the party leadership. The outcome of that race will essentially decide Japan's next leader.

The government on Friday offered a pessimistic view of the economy. Japan's consumer prices continued to decline in July for the 17th straight month, another sign that the economy remains mired in a deflationary spiral that is pushing down prices, wages and demand. The yen hovered near a 15-year-high against the US dollar, trading at 84.64 yen a dollar at 4:50 pm in Tokyo.

The fate of the DPJ presidential race has far-reaching implications beyond the domestic arena of politics. Ozawa has said that the US 7th Fleet, based in Yokosuka, Kanagawa prefecture, would be enough to secure the US presence in the Far East from a strategic viewpoint - suggesting that he supports withdrawal of all other US forces from Japan, including the controversial US Marines Corps base in Okinawa.

In December, Ozawa, then secretary general of the DPJ, accompanied more than 600 people, including 143 DPJ lawmakers from the upper and lower houses of the Diet (parliament), to Beijing - showing his pro-China stance as a direct successor of former prime minister the late Kakuei Tanaka, who broke the ice to normalize Japan-China relations in the early 1970s.

The Destroyer
Ozawa, a shrewd veteran lawmaker and former Liberal Democratic Party secretary general, has earned himself the nickname "The Destroyer", a Japanese version of the Hindu god Shiva the Destroyer, for his record of creating and breaking up parties and for crushing personal ties and letting go of many talented aides.

He stepped down as DPJ secretary general in June, wounded by a political donation scandal that has already led to the arrest of his three secretaries, along with the party's then-leader and prime minister, Yukio Hatoyama.

Ozawa still has past accounting violations at his political fundraising organization, or Rikuzankai, hanging over his head. He could be brought to trial, depending on a ruling by a citizens' panel expected as early as October. But should he become the next prime minister, the law could protect him from indictment for the duration of his tenure for a questionable land transaction by his implicated fundraising body.

Strong-arm tactics and risk-taking
Although he conjures up tainted images as a politician among ordinary people, more than a few lawmakers and some business leaders expect Ozawa to boldly address national problems through his strong-arm tactics and risk-taking - by confronting and reining in the bloated bureaucracy, including the Ministry of Finance and the Bank of Japan, and then taking more pump-priming measures.

Ozawa decided to throw his hat into the ring for the presidency of the DPJ as he felt a restless urge about the future of his fading political influence, Minoru Morita, a noted political analyst based in Tokyo, said.

"Heading into the party election, Kan refused to accept Ozawa’s demands, such as the dismissal of chief cabinet secretary Yoshito Sengoku and current secretary general Yukio Edano, both Ozawa foes," Morita told Asia Times Online on Friday. "This made Ozawa decide to run for the election. For sure, he is damned if he does so because he resigned as the DPJ's secretary general less than three months ago. But he would also be damned if he doesn't, because he surely faces the end to his career by losing his political power."

"If the presidential election were held today, Kan would beat Ozawa because of the strength of the incumbent premier holding power and position," Morita said. "But in the DPJ presidential election scheduled for September 14, there would have been a major reversal in this situation. Ozawa may win."

Japanese economists and market participants are divided over the prospects of the economy should Ozawa take over as prime minister.

Critics view Ozawa as a fiscal expansionist by sticking to the party's 2009 platform that was criticized as rampant spending. They predict extra spending could trigger selling in Japanese bonds and the yen, just like with Greek bonds and the euro.

Proponents, meanwhile, say Ozawa would be better to tackle the rising yen and falling Japanese stocks by taking aggressive measures, much more so than Kan, who seems to have fallen behind the curve since taking over in June this year, even though Kan was a finance minister.

A Japanese proverb says, "One poison drives out another." Ozawa may be a tainted hero who could cause major political and economic change. People are increasingly focusing on the DPJ presidential race - it could be a good measures of how much ordinary people want a leader to revive the fading country, once called an "Economic Animal" and now facing a "lost three decades".

Kosuke Takahashi is a Tokyo-based journalist.

(Copyright 2010 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

"ANPO" Trailer

Praying for World Peace

Today is the 65th anniversary of the end of the World War 2.

Japan is also in the Obon season, which is from August 13th to the 16th. Obon is a Buddhist festival to recognize ancestral spirits. It is believed these spirits return to our families during the period. We visit our ancestral graves and make offerings of flowers and incense.

The photo above is my great-grandfather, Yonosuke Goto, who died in 1925 at the age of 33. That was before the war. I personally offered a one-minute silent prayer to mourn the victims and wish for world peace.

Michele Flournoy: U.S.-Japan alliance a cornerstone in a complex world

Michele, I am sorry to say this. With Japanese public debts amounting to 218 percent of gross domestic product at the end of 2009, you need to think about the alleviation of Japan's financial burdens for the costs of maintaining American troops in Japan. Cheers, Kosuke



POINT OF VIEW/ Michele Flournoy: U.S.-Japan alliance a cornerstone in a complex world

SPECIAL TO THE ASAHI SHIMBUN

2010/07/16

As we celebrate the 50th anniversary of the U.S.-Japan Treaty of Mutual Cooperation and Security, we should all take a moment to appreciate the critical contributions the alliance has made to the international community.

There have been many challenges over the last 50 years, and there are bound to be more in the future. But the alliance has shown that it is mature, strong and enduring.

The American and the Japanese people have never lost sight of the shared values, democratic ideals and common interest in peace, stability and prosperity of the Asia-Pacific region that make for an unshakable alliance.

As President Barack Obama and Prime Minister Naoto Kan recently affirmed at the Group of 20 summit in Toronto, the U.S.-Japan alliance continues to be indispensable not only for the defense of Japan, but also for the peace and prosperity of the entire Asia-Pacific region.

The positive value of the U.S.-Japan alliance is not lost on other countries in the region; the enduring presence of U.S. forces in Japan is the bedrock for prosperity in the region.

The continued U.S. presence provides deterrence against acts of aggression and reassures other nations in the region. This presence, and the benefits it provides, is supported by significant Japanese financial contributions. This financial support is essential to the ability of the United States to maintain some of the most advanced military capabilities in the world in Japan. Japan's contribution also supports the U.S. service members prepared to risk their lives in defense of Japan and peace and security in the Asia-Pacific region.
In addition to providing deterrence in a still uncertain region, the presence of U.S. forces allows the United States and Japan to respond to humanitarian and natural disasters and to save lives.

With close logistics and operational support from Japan, U.S. forces quickly responded to crises such as the 2009 typhoons in the Philippines, the 2008 Cyclone Nargis in Burma (Myanmar) and the 2007 Cyclone Sidra in Bangladesh. Japanese Self-Defense Forces (SDF) are increasingly deploying alongside their American partners to address humanitarian challenges in the region, as they did in responding to the 2004 tsunami. For example, earlier this year, Japan deployed the SDF via U.S. mainland bases to provide critical relief to Haiti following that devastating earthquake. The U.S. Navy and Japan's Maritime Self-Defense Force (JMSDF) have conducted humanitarian civil assistance activities in Cambodia and Vietnam as part of the PACIFIC PARTNERSHIP 2010 operation. Going forward, humanitarian assistance/disaster relief cooperation will provide countless opportunities for the U.S.-Japan alliance to contribute to the welfare of the region and the world.

The United States and Japan also cooperate closely to ensure that every nation has the right to freedom of navigation and access to open sea lanes, thereby providing for the safety of mariners and the security of trade in and out of the region. The JMSDF and the U.S. Navy work hand-in-hand to respond to the recent proliferation of pirate attacks on shipping in and around vital sea lanes, especially off the Horn of Africa.

Japan and the United States are partnering to contribute significant resources to building peace and stability in some of the most war-torn places in the world. For example, in Afghanistan and Pakistan, we are cooperating to implement reconstruction and stabilization measures.

Over the next 50 years, the United States and Japan look forward to deepening our level of cooperation on other issues as well, particularly in the area of regional missile defense.

Japan's decision to invest in advanced AEGIS destroyers, upgrade its Patriot missile battalion, and cooperate with the United States on a next generation of missile defense systems, underscores a firm commitment to enhancing regional deterrence.

The United States and Japan will look to grow our partnership in the areas of space and cyber cooperation. As the world becomes increasingly interconnected, we recognize the need to strengthen our cooperation under the alliance to promote the security of the global commons, including space and cyberspace.

As we move into the future, we will also look to develop new programs for cooperation, like "Green Alliance" initiatives, which aim to promote the use of environmentally friendly technology on Guam and Japan. We also aim to enhance cultural exchanges, education programs and research partnerships.

It is often said that the strength of any relationship can be measured by how well it manages challenges, conflicts and crises. Over the past 50 years, the U.S.-Japan alliance has endured all three and emerged stronger and ready to address the challenges of the 21st century.

Whether it is working to secure the sea lanes of maritime trade, addressing the challenges posed by the potential spread of weapons of mass destruction, or responding to an increasing array of humanitarian and disaster relief crises around the globe, the U.S.-Japan alliance remains a security cornerstone in a complex world.

* * *

The author is the U.S. undersecretary of defense for policy.

(WSJ) Okinawa? Marines Out, Says Barney Frank

July 12, 2010, 3:02 PM JST.

Okinawa? Marines Out, Says Barney Frank.

Okinawans seeking to oust the U.S. Marines from their midst have a prominent new advocate in Washington: Veteran Democratic Congressman Barney Frank.

The aptly named Mr. Frank, one of the most quotable politicians from either of America’s big two political parties, has been hitting the talk show circuit over the past week with memorable one-liners on the matter. “Most people, I think, that I talk to, thought the Marines left Okinawa when John Wayne died,” he said on MSNBC’s “Morning Joe” show on July 8, referring to the long-gone Hollywood star’s World War II movies. “It’s unclear to me what they’re doing there.”

He went on: “I don’t want to see China given a free hand over there vis-a-vis Taiwan, but 15,000 Marines aren’t going to land on the Chinese mainland and confront millions of Chinese soldiers. You need some air power and sea power.”

The liberal Massachusetts Democrat was given the microphone in recent days after penning a widely-cited odd-couple op-ed with libertarian Texas Republican Rep. Ron Paul on July 6 calling for sharp cuts in the Pentagon budget, particularly on spending abroad. While the piece itself doesn’t mention Okinawa, Mr. Frank cites Japan’s southern island repeatedly in interviews as a prime exhibit of what he considers wasteful World War II legacy spending that has become irrelevant in the 21st century.

“We don’t need 15,000 Marines in Okinawa,” Mr. Frank told National Public Radio July 10. “They’re hanged-over (sic) from a war that ended 65 years ago.”

Many American policymakers would beg to differ, as would the Marines. Lt. Gen Keith J. Stalder, Commander of U.S. Marine Corps Forces Pacific told The Wall Street Journal in February that the Marine presence in Okinawa was a crucial part of American force projection in Asia, a factor preserving broader regional stability. “There is nothing that happens in the region that will not affect Japan in a very negative way if it’s not contained quickly or prevented,” he said.

It’s unclear just how far Mr. Frank can go with his crusade. While he is influential within his party, his clout is greatest in the House Financial Services Committee, which he chairs — not military policy. But at a time of economic angst, and growing pressure to cut spending, Mr. Frank’s rhetoric could gain traction, especially as leaders in Okinawa make clear they don’t want the bases there either.

“We don’t get any jobs out of Marines in Okinawa…,” Mr. Frank asserted to MSNBC host Keith Olbermann.

Waiting for the EU Stress-Test Results

This week on Nikkei CNBC programs I need to speak a lot about the EU Stress-Test results scheduled to be released on July 23. Many investors are also anxious about them. Here are interesting articles. Just FYI.
Cheers, Kosuke

91 Banks + 20 Nations = Stress Test Overload

Next Friday, news screens may be straining with information overload as stress test results are published.

The publication of stress test results for European banks looms large as midsummer’s event for financial Europe next Friday. It also could make for a few frightful hours if the results are released helter skelter from myriad sources, as early information suggests.

Banking sources are beginning to shed early light on how the results will be disclosed. If true and left unamended, it could involve a blizzard of releases from national regulars and the individual banks at 1600 GMT.

In Spain, for example, banking industry sources say that the local banking associations representing Spanish banks and the savings banks will post the test results of individual members on their websites. The Spanish central bank will then publish a report on how the sector did as a whole.

Multiplied by the 91 banks and 20 nations being tested by the Committee of European Banking Supervisors (not including Switzerland), the event will have news screens straining with information overload.

Final disclosure plans are still pending. But some could argue that a more controlled, uniform and consolidated release source could smooth market absorption and the chance of error.

“Hopefully,” economists at UniCredit write to clients, “the exercise will be handled professionally enough to avoid a major accident.”

WEEKEND INVESTOR
JULY 17, 2010.

Playing the EU Stress-Test
By BEN LEVISOHN

Sometimes stress can be profitable.

On July 23, European regulators will release the results of its "stress tests," designed to gauge the ability of Europe's banks to withstand future economic shocks. If all goes well, the tests could signal an end to the crisis of confidence in Europe and global markets in general, at least in the short term.

Traders already are placing bets on a European bank rebound. The Markit iTraxx Europe Senior Financial Index of credit-default swaps on 25 banks and insurers, which tracks the cost of insuring against a bank default, fell 0.33 percentage point during the past month and is near its lowest level in almost three months. The financial-services sector of the Russell Developed Eurozone Index, meanwhile, has risen 14% this month through July 14, after having fallen 30% during the first half of 2010.

Investors should tread carefully, however. When the U.S. conducted similar stress tests in early 2009, bank stocks rallied for two months before the results came out—then fell 14% over the following two months, even though the results were mostly positive.

"We see relative strength as a good opportunity to take profits," says Chad Deakins, portfolio manager of the $250 million Ridgeworth International Equity Fund, which is overweight European financials.

But by differentiating between the strong and the weak, the stress tests may help to restore confidence in higher-quality European banks, which should benefit longer-term investors. In the U.S., bank stocks as a group were 12% higher on the one-year anniversary of the stress tests. U.S. Bancorp jumped 29% during the period, while BB&T rose 27% and Capital One gained 59%.

Despite strong capital levels and exposure to markets outside Europe, banks such as Spain's Banco Santander SA and France's BNP Paribas have been tarred with the same brush as weaker competitors on the Continent. Although they have gained as much as 43% during the run-up to the stress tests, they seem attractive over the long term, says Fred Rizzo, a London-based European bank analyst at T. Rowe Price.

A broader way to play Spanish banks in general and Santander in particular is via the iShares MSCI Spain Index exchange-traded fund, which has 47% of its portfolio in financials and one-quarter of its assets in Banco Santander. If Spain's publicly traded banks come through the stress tests better than expected, these stocks could give the fund a boost.

Thanks in part to Europe's banking woes, the entire Spanish market looks cheap on a valuation basis, says Leila Heckman, a Chicago-based senior director at Mesirow Financial, which manages more than $35 billion in assets. Stocks there are trading at a price-earnings ratio of 10, compared with a long-term average of 14 times.

The Netherlands, which has few of the issues plaguing its peripheral peers, is a safer play, Ms. Heckman says. The iShares MSCI Netherlands Investable Market Index ETF provide exposure to the Dutch market and Dutch banking giant ING Groep makes up 11% of its portfolio.

"Just a month ago, the fear was that Europe was taking everything down with it," says Michael Hasenstab, who oversees the $35.4 billion Templeton Global Bond Fund. "That won't be the case," he predicts.

Investors wary of buying stocks or funds outright could hedge their bet using a "covered call" strategy. It boils down to buying a stock while selling a call option, or the right to buy the stock at a certain price. The main drawback: If the stock rallies too much, you will be forced to sell below the peak. But the "premium" you rake in from selling the call can mitigate a loss should the stock price fall.

Even the shares of Allied Irish Bank, one of the most troubled of Europe's banks, seem more attractive in a covered-call trade. In Friday's market, the stock fetched around $2.28 on the New York Stock Exchange. By selling a February call with a strike price of $2, an investor can rake in a premium of 65 cents a share, or $650 per 1,000 shares. That is a 23% return if AIB is trading above $2 a share when the option expires. On the flip side, shares of AIB can drop to $1.63 before investors take a loss.

"We think Allied will come back," says Vic Schiller, president of options-research service InvestorsObserver. "But by using the right covered-call strategy it can drop 28% and you won't lose a penny."