16 Should then regional trade liberalization among SEE-5 economies be a policy priority? If this were the only dimension of trade liberalization being pursued, the answer would be unequivocally negative unless accompanied by strong MFN liberalization.

This analysis points to the importance of designing the pace of SEE-5 mutual trade liberalization in ways that would both reduce incentives to shift industrial activity from poorer to richer countries of the region and to trade diversion due to SEE-5 small economic size. Openness to the external world is the best solution to both negative outcomes, as it scales down preferential margins enjoyed by SEE-5 producers in SEE-5 markets. Low MFN tariff rates lessen the level of protection given to firms including those from more developed SEE-5 countries. So do lower preferential tariff rates on imports from the EU.

Hence, two practical policy recommendations follow from this analysis. First, the time during which firms from SEE-5 and other MoU signatories would enjoy preferential tariff margins over suppliers from the EU should be shortened. This would suggest a faster reduction of tariff rates on imports from the EU. Second, high MFN tariff rates on industrial products should be significantly lowered with the entry in force of FTAs. This would reduce the level of protection accorded to SEE-5 firms that may be competitive in other regional markets thanks to high tariffs.

# **4. INTRA-SEE-5 TRADE: POTENTIAL FOR GROWTH AND IMPLICATIONS FOR FTA**

Developments in intra-SEE-5 trade, its composition and the extent to which this trade remains below its potential because of the legacy of political tensions are relevant for an assessment of FTAs among SEE-5 economies. Will the proliferation of FTAs elicit strong trade response from new participants? What is the potential for the increase in trade among countries some of which were part of the same state only a decade ago? These are among main questions addressed in this section.

Geographical proximity, the size of economies entering into the FTA and the level of trade among them influence the balance between benefits and costs to its participants. If countries entering an agreement are closely located and already have significant trade turnover, i.e., they are 'natural' trading partners, then positive effects are likely to exceed negative ones. Similar positive effects would seem to prevail if mutual trade, despite geographical proximity, was suppressed for non-economic reasons, as was the case of several former Yugoslav republics.

What is the current potential for the expansion of this trade? In other words, the question is whether SEE-countries under-trade among themselves. Because of the inherited distortions and the low quality of available trade data, there is no single method to obtain an unequivocal answer to this question. Consider first the available data. As can be seen from Table 3 comparing SEE-5 export statistics with mirror statistics for the same flows, differences between the values of exports to other SEE-5 countries and corresponding imports from these countries are huge. They are well over 10-15 percent usually regarded as reflecting differences in counting respective values of exports and imports. Differences in valuations or the standard inclusion in the value of imports of cost, insurance and freight cannot explain them. These usually do not account for more than ten percent. Moreover, the values of exports should be lower than the value of corresponding imports. Except for Albania and Croatia (see corresponding columns in Table 3), the values of export to import indices are significantly larger than unity. While this is the case of all other SEE-S, these values are particularly high for FR Yugoslavia. As can be seen