India is struggling with a record current accounts deficit in the midst of an economic slowdown, and the government says the #1 culprit is gold imports. India is the world's largest importer of gold, with a total of around 800 tons, worth $58 billion USD, imported last year.
In an effort to curb the nation's long-standing love affair with the yellow metal, the government has hiked import taxes on refined gold from 4% to 6%, and the tax rate on raw gold (gold doré) from 2% to 5%. Importers had been buying doré, which is poured at the mine from raw ore and contains other metals, at the lower tax rate and refining it domestically to save money. The tax on refined gold follows one made less than a year ago that increased the tariff from 2% to 4%, but did little to decrease demand.
In a nation where the inflation level unexpectedly dropping to 7.18% last month was met with cheers, the people are deeply ingrained in the habit of putting as much of their weakening rupees into gold as possible in order to preserve wealth. Gold is a traditional wedding and holiday gift in India, a tradition that will not change soon, if ever.
Importers and jewelers in India bought up stocks in early January ahead of the tax hike. The drop in gold prices at the start of the year allowed them to buy even more. UBS noted that "During the first week of January, our flows to India indicated a notable pick-up in demand shortly after the initial headlines flagging the potential tax hike were released. In a sense, the move was anticipated -- local participants typically front-load their buying when there is a considerable threat of an increase in customs duties..."
Having bought up enough gold to last a while, imports by India will be muted in the near future, by which time public sentiment may have grown used to the new taxes. But, when official channels cannot meet demand, "unofficial" channels spring up to meet that need. After the tax hikes on gold in early 2012, seizures of smuggled gold tripled, and has become a major problem for the government.
Local jewelers are not worried about the long-term effects of the new taxes. Prashant Tejnani, whose family has been in the jewelry business for 50 years, is the owner of a jewelry store in Mumbai. "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 told CNBC on Tuesday.
There may be relief from high gold prices, if the Indian government can control a record budget deficit and improve the economy. Since gold (and many other commodities) are sold in U.S. dollars, a weaker dollar or stronger rupee brings prices down for Indian buyers. The New Delhi government has slashed fuel subsidies to cut the budget shortfall, and has promised to streamline the convoluted process of approving industrial projects. This news, combined with the new gold taxes to curb imports, helped the rupee hit a 3-month high recently. If the government can reign in spending, the strengthened rupee may help Indians from being caught in a "golden squeeze."