Is India fighting a losing battle against gold bugs?

July 31, 2016

By Ansuya Harjani, CNBCGlobalPost Writer

An Indian customer tries on a piece of gold jewelry.
Manjunath Kiran

Prashant Tejnani, owner of a jewelry store in India's financial capital Mumbai, said news of the government's latest tax hike on gold imports sent an initial wave of panic through vendors in the city's bustling Zaveri Bazaar, or jewelry market – but he expects the impact on demand to be fleeting.

"Gold will always retain its shine in India. An increment of 2 percent will curb demand initially, for one or two months, but once people get used to it, they won't mind paying the extra," Tejnani, whose family has been in the jewelry business for 50 years, told CNBC on Tuesday.

Gold is India's second largest import after oil and has led to an increase in the country's current account deficit which stood at 5.4 percent of gross domestic product in the July-September quarter. This insatiable appetite for gold led the government to increase the tax on its import to 6 percent, from an earlier 4 percent, on Monday.

(Read More: India Raises Gold Import Tax)

India has been actively targeting gold imports over the past year. In March 2012, the government doubled the import duty on the precious metal from 2 to 4 percent, following a tax increase in January.

While the taxes initially helped slow Indian demand, import volumes recovered soon after. For example, gold imports rebounded to 223 tonnes in the third quarter, after falling to 131 tonnes in the previous three months.

Gold, in both bullion and jewelry form, is widely regarded as a store of wealth among Indians of all income groups, and is traditionally gifted during weddings and religious occasions. The precious metal is also seen as an inflation hedge in a country which has been suffering from unabated price increases.

Commodity analysts said the government's most recent step will have a limited impact on demand and hence on the price of the precious metal in the country. The positive outlook for the rupee will also offset some of the impact from the tax hike, said experts.

"I am less concerned by this (tax), than with the level of the rupee which will have a much larger impact on the local currency gold price. A strengthening rupee in 2013 would easily compensate for any tax increase," Warren Gilman, CEO of CEF Holdings.

The rupee – which has weakened almost 7 percent against the U.S. dollar over the last 12 months – is beginning to stage a turnaround, touching a 3-month high on Tuesday, a day after the measure was announced in an effort to narrow the current account deficit. And, some strategists believe the currency could be among the top performers this year.

Nick Trevathan, senior commodity analyst at ANZ Bank, agreed that a strengthening rupee would help offset the tax burden for consumers, adding that while the tax hike may weigh on sentiment in the near-term, Indian demand is highly robust.

"There have been three rounds of tax hikes now, so the market seems a bit more accustomed by these moves," he said.

Trevathan noted that while the latest tax moves would result in a decline in "reported" gold imports, he expects a rise in black market activity as buyers attempt to evade the increased duties.

Following the first two rounds of import tax hikes in 2012, the government reported a 300 percent jump in seizures of smuggled gold in the April-June period last year, valued at $169 million, according to ANZ.

"Additional taxes and restrictions on imports will only serve to divert more of India's gold demand into the black market," he said. "Ultimately we do not believe this regulation will address the country's current account gap."