35 reorientation took place during the initial stages of transition from central planning rather than during the period of accelerated cuts in preferential tariff rates on manufactured goods in the second half of the 1990s and early 2000’s. While no data are available for all CEEC-10 economies, it is rather unlikely that they diverged from the pattern observed in Hungarian, Polish and Romanian imports where the largest increases occurred over 1990-92 (Table 16 above).

Why were the shares of manufactured imports from preferential sources in total imports of manufactures immune to the degree of reverse discrimination? There are two explanations. First, MFN suppliers may lower export price to stay competitive in Bulgarian markets.<sup>30</sup> Second, authorities may resort to tariff exemptions. This practice appears to be quite widespread. As a result, not all importers have to pay high duties on their MFN supplies. For instance, goods imported by firms operating in Bulgarian Free Trade Zones and economically depressed areas, were exempt from duties. So were some imports of capital equipment. This has weakened the trade diversion effect usually triggered by high preferential margins.

Both practices are distortionary, however, in spite of their apparent little impact on direction of foreign trade. They have negative impact on Bulgaria’s competitiveness in global markets, as it affects their ability to access the best inputs available worldwide and unnecessarily increased administrative micromanagement of trade flows.

High MFN tariff rates are not only redundant but are also a bad trade policy. Shortcomings of regional liberalization unless accompanied by simultaneous liberalization of MFN tariff rates are twofold: First, reverse discrimination often suppresses FDI inflows from firms located in non-preferential countries unless they are able to outsource to suppliers from Bulgaria’s preferential patterns. Second, high MFN tariff rate raise prices of imports and thus may undermine export competitiveness of Bulgarian exporters. While in many cases indispensable imports are available from preferential partners, this is not always the case, as highly specialized machinery may be only available in, for instance, Japan or the United States. High tariffs put Bulgarian firms in competitive disadvantage vis-à-vis firms operating in countries with lower tariff rates.

In fact, there is no reason to maintain high MFN applied tariff rates on industrial imports, as MFN tariff rates offer neither protection to domestic producers nor generate significant customs revenues. High tariff protection in Bulgaria is redundant, as more than 80 percent of manufactures and slightly less than 80 percent of industrial products originate in ‘pan-European’ countries and therefore do not face any tariff barriers in access to Bulgarian markets. In the absence of extensive regional trade arrangements, tariff protectionism can be defended (or explained) in terms of infant protection argument, government revenue needs or political economy reasons related to political pressures from powerful interest groups. If, however, the same sectors are open to duty-free competition from firms from such highly developed economies as the EU, not to mention, the internationally competitive imports from other recent EU entrants, none of the above applies unless a protected product is not manufactured in any of FTA countries. This is hardly a plausible occurrence, as a ‘pan-European’ free trade area for industrial products is an economic superpower. Under these circumstances, maintaining high MFN tariffs amounts to protecting FTA suppliers from MFN competition and has a negligible effect on competition from imports faced by domestic producers.

# **3.4. “Shadow” customs union with the EU on industrial products**

Faced with the raising welfare costs associated with high preferential margins, the best policy option for a small country is usually free trade. Considering, however, Bulgaria’s involvement in the EU accession process, this option is not acceptable, as it might trigger demands for compensation from Bulgaria’s MFN trading partners once Bulgaria becomes a member of the EU. Under these circumstances, the best policy option is that of adopting the EU’s MFN CET on industrial products.<sup>31</sup> 30 Chang and Winters (2002) provide empirical evidence showing that firms lowered their export prices offered to consumers from MERCOSUR countries in order to compete with firms from this regional trading bloc.

31 Although upon accession Bulgaria will adopt the CET, there remains still around two years before this happens.