By Carol Giacomo, Diplomatic Correspondent

WASHINGTON, March 4 (Reuters) - As the United States and North Korea prepare to discuss normalizing diplomatic relations on Monday, many pitfalls threaten the process, including U.S. promises to discuss lifting sanctions and removing Pyongyang from the U.S. terrorism list.

The New York meeting between U.S. Assistant Secretary of State Chris Hill and North Korean Vice Foreign Minister Kim Kae-gwan goes to the heart of what Pyongyang wants out of the newly resurgent diplomacy -- official ties with the world's superpower and guarantees its communist system can survive.

If afterward "North Korea comes out and says the United States has a hostile policy and isn't lifting sanctions as promised, then we have a problem," said Michael Green, formerly an Asia expert on President George W. Bush's National Security Council.

"But if the North Koreans engage in real discussions about what they have to do on terrorism and (counterfeiting) and so forth to move to sanctions-lifting, that would be a good sign," said Green, now with the Center for Strategic and International Studies think tank.

The U.S. and North Koreans are meeting as one of five working groups established by a Feb. 13 agreement under which Pyongyang, which conducted an underground nuclear test in October, promised to to move toward nuclear disarmament in exchange for $300 million in aid and prospects for other benefits.

The other working groups focus on North Korean-South Korean relations, North Korean-Japanese relations, denuclearization and regional security.

It will be the highest-level meeting on U.S. soil since North Korean leader Kim Jong-il's special envoy, top military officer Jo Myong-rok, visited Washington in 2000.

INITIAL PHASE

During an initial 60-day phase, the two sides are to start talks aimed at resolving bilateral issues and moving toward full diplomatic relations which have not existed since the 1950-1953 Korean War.

Also, Washington should begin the process of removing North Korea's designation as a state-sponsor of terrorism and discuss removing further sanctions under the Trading with the Enemy Act.

Beginning a process is one thing, however. Changing policy is another. Both sides want firmer guarantees on when the other's promises will be fulfilled. There are timelines for what happens in the first 60 days but not thereafter.

Washington has said it was ready to resolve the case against a Macau bank that resulted in the freezing of $24 million in North Korean accounts linked to counterfeiting. But no money has yet been released.

One early potential flash point is North Korea's removal from the U.S. list of countries that sponsor terrorism.

Japan has urged its ally to wait until the issue of Pyongyang's abduction of Japanese citizens is resolved.

Charles Kartman, the Clinton administration's North Korea negotiator, said removing North Korea from the terrorism list should be easy because the abductions, while heinous, are "an old crime."

"There's no real reason to keep them on the terrorism list that I know of," he said in an interview.

But the administration, which in 2003 said it would not lift the terrorism designation without progress on abductions, is worried about a break with Japan if it moves too quickly.

The North's denuclearization pledge is handled by another working group. But since that is the main U.S. goal, experts say Hill is certain to press Kim on what Pyongyang should disclose on its list of nuclear programs due in April.

The United States is wary of giving the North too much aid, sanctions relief or recognition before it abandons its nuclear programs. Moreover, Washington has made clear that full normalization will require improvement in Pyongyang's human rights record, which could take years.

Meanwhile, Pyongyang, distrusting Washington, is reluctant to surrender its only bargaining chip -- nuclear capability.

Washington has played down the Monday meeting but experts say if it goes well, it could result in a visit to Pyongyang by Hill. If it goes badly, it could give hard-liners in both capitals new fodder to undermine the diplomatic process.

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