13 the European Economic Area (EU-EFTA), and the introduction of simple rules of origin based on diagonal cumulation. In addition, as suggested above, SEE-5 countries might lower their MFN tariffs at the pace set in SAAs for the reduction of tariffs on their imports from the EU. Combined with efforts to harmonize taxes on goods and services collected at border, this would encourage development of horizontal links among SEE-5 firms and weaken incentives to trade deflection and smuggling.

In all; trade liberalization in both dimensions-the European dimension and the intraregional dimension-calls for a very careful coordination of the pace of liberalization not only between these two dimensions, but also with multilateral liberalization. MIFN liberalization, liberalization in trade with the EU and in that with other SEE countries should be regarded as components of integration into global markets. The remainder of this paper seeks to identify measures along these three dimensions of integration into global markets that offer the greatest potential for gains to SEE-5 countries.

# **3. DANGERS OF INTRA-REGIONAL LIBERALIZATION: SEE-5 FTAs**

Benefits from FTA depend on who is integrating with whom. Taking into account the level of economic development, two cases are relevant for this discussion-North-South integration and South-South integration. Integration into the EU is the case of North-South integration, whereas SEE-5 intra-regional integration falls into the South-South integration, albeit among countries at different levels of economic development and dependence on foreign markets. The former involves integration between highly developed countries and developing countries, whereas the latter concems integration arrangements among developing countries. Providing that integration goes beyond trade, benefits to a 'South' country integrating into a 'North' country are huge, as it pushes the former to become like the latter.

Institutional convergence improves investment climate and boosts investments. The empirical evidence-supported now by theoretical economic geography models-suggests that EU integration has led to an almost **_continuous convergence_** in income per capita among member countries (World Bank 2000a). As a rule, poorer members of the EU have experienced faster economic growth and caught up with the most developed ones as a result of policy-induced integration. The theoretical explanation of this phenomenon is that if a country with capital to labor endowment below the world average integrates with a country with the ratio exceeding the world average, the former country experiences acceleration in industrialization.

On the other hand, benefits from 'South-South' integration are problematic depending on the design of a regional trade arrangement. No convergence in income per capita occurs in the case of policy-induced integration among less developed countries. In fact, when two countries involved in regional integration have capital to labor endowments below the world averages, the one with a higher average expands at the expense of a less developed partner. The scope of this effect depends on the level of preferential tariff margins-high extemal tariffs exacerbate the move of manufacturing production out of a less developed to a more developed "Southern" country. Ultimately, the extent of divergence depends also on the level of preferential tariff margins; the higher they are the more pronounced relocation of economic activity to a more developed partner is. In fact, the empirical evidence from the South-South integration<sup>provides</sup>