32 results in a partner country’s production displacing higher cost domestic production, it does not increase “regional” trade at the expense of outside countries and yields static benefits to FTA participants. The FTA has the potential for increasing welfare of both partners only insofar as trade creation exceeds trade diversion. In other words, a country can lose when it liberalizes on a discriminatory basis, if the cost of trade diversion outweighs the benefits from trade creation.

Large theoretical literature on bilateral trade integration offers many rules of thumb as to when FTA is likely to result in welfare loss or gain (see Baldwin 1991, Schiff and Winters 2003, World Bank 2000). The “North-South” integration, as exemplified by the EU Eastern Enlargement project provides incentives to a ‘South’ country to become gradually like a ‘North’ country in terms of institutions and policies. These incentives derive not only from aspirations to accede to the EU, which calls for the convergence of domestic regimes to the _acquis communautaire_ but also from opening of the economy to competition from imports from the EU and better access to EU markets. The latter may contribute to the increase in foreign investment inflows.

But there is also potential for welfare loss even in the case of ‘North-South’ integration. The most important and enduring ones concern MFN tariffs and the fraction of imports that come from other participants in FTA. High and dispersed MFN external tariffs, that is, high reverse discrimination and low mutual trade are conducive to trade diversion. High preference margins (or reverse discrimination) provide a strong incentive to home consumers to switch from a low-cost supplier outside the FTA to a high-cost one from a FTA partner country. The level of pre-FTA trade with an FTA partner affects the size of trade diversion effect. If initial pre-FTA imports are low, the likelihood of replacing a low-cost MFN supplier with a higher-cost FTA supplier increases.

Last but not least, there is a danger of trade deflection if MFN applied tariff rates vary across countries of a free trade area. Traders then have incentive to seek to enter through a ‘lower tariff’ country, obtain a fraudulent certificate of origin and move a shipment to a ‘higher tariff’ country resulting in losses of customs revenue. The extent of trade deflection depends on tariff differentials and the quality of customs administration—high differentials and corrupt customs lead to high trade deflection.

‘Pan-European’ arrangements denote broadly the trade component of the European Association Agreement effective as of 1994, Bulgaria’s participation in CEFTA (Bulgaria joined in 1999 liberalizing market access for then six other CEFTA members) as well as other parties of the Pan-European Cumulation of Origin Agreement, that is, Romania and Turkey. Turkey has had customs union agreement with the EU since 1997 and applies the EU Common External Tariff on most products. Taking into account schedules of tariff reductions on industrial imports, since around the end of the 1990s most tariff rates on industrial products from pan-European countries have been zeroed. As for other FTAs—with SEE-5 countries and Israel—most industrial products under these agreements either already or soon will have duty-free access to Bulgarian markets.

Bulgaria’s applied MFN tariff rates on industrial products create significant potential for reverse discrimination. Data tabulated in Table, based on six-digit Harmonized System (HS) tariff lines processed for UNCTAD TRAINS database, offer insights as to its potential scope—potential, as the information is limited to imports by six-digit HS items without identifying whether these imports come from preferential partners. In other words, MFN tariff rates are not applied to all imports of six-digit HS items, yet the database provides information on all imports in 2003, from preferential and MFN partners alike. Had Bulgaria had no FTAs, 21 percent of its imports in 2003 would have been subject to zero tariff rates and 20 percent to MFN applied tariff rates exceeding or equal to 15 percent (Table 13).

But this was not the case. In fact, the bulk of Bulgarian imports of industrial products were duty-free. Since duties on industrial imports from ‘pan-European’ countries were zeroed in 2003, the MFN applied tariff rates represent preferential margins enjoyed by ‘pan-European’ suppliers in Bulgarian markets vis-à-vis MFN ones. The ‘pan-European’ share in Bulgarian imports of industrial products was 76 percent in 2003, that is, at least 76 percent of industrial imports that entered Bulgaria were not subject to tariffs. But the actual share of duty-free imports may be much larger.