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Two news items from India this week - a surge in Indian gold imports this month and the Reserve Bank of India cutting interest rates - have prompted this closer look at what's going on in the subcontinent as policy makers grapple with economic troubles and the domestic gold market.

Sadly, as it relates to the government once again hiking import duties to deter gold demand last week, an effort aimed at lowering their trade deficit and bolstering the currency, it seems clear that this initial assessment in an article from the other day got it about right:

This is a fascinating development - a government taking steps to curb demand for what has served as a store of wealth and an important part of the culture for centuries in order to help bolster the government's paper money amid persistently high inflation.

So, what's going on?

Last week, the Indian government raised the import duty on gold from four percent to six percent, this after twice doubling the duty last year from just one percent. The move was aimed at discouraging gold buying that accounts for just over 10 percent of the nation's troublesome trade deficit, though oil imports are a much bigger share at about 30 percent.

The first tip-off that there's something seriously wrong here is that the government subsidizes energy prices to the public - they're making consumers pay more for what contributes 10 percent to the trade deficit while artificially lowering the price for what contributes 30 percent.

If they were serious about reducing their trade deficit, perhaps they'd raise the price of energy products rather than lower them, however, that would surely make inflation go even higher, a subject we'll get to shortly.

Over the last year or so, the rising trade deficit has been a key factor in the weakening of the nation's currency (the rupee) while also increasing India's need for foreign capital inflows.

A weaker currency leads to falling confidence by foreign investors, making financing the nation's current account deficit more difficult, and this has spurred painful memories of a crisis in 1991 when, in order to avoid a debt default, India sent 47 tonnes of gold to Europe as collateral for new loans.

In a world full of freely traded currencies backed by nothing more than confidence in the government that issues it, gold demand in India is seen as playing a key role in weakening the nation's paper money and imperiling its finances, so now the government is doing something about it.

If you haven't already figured it out by now, they're attacking the symptoms of the problem, not the cause.

Gold imports surged during the first few weeks of the year after policy makers first floated the idea of yet another duty hike and imports are believed to have increased to 75 tonnes for the month, up from 65 tonnes a year ago.

As was the case after the duty increases in early-2012, gold demand is expected to dip for a while, but it will likely return as it did last year when India became "the strongest performing market in the third quarter", according to a World Gold Council report.

It seems that, despite the efforts of their government, the Indian people still want their gold.

After the latest duty hike the gold price is now seven percent higher inside of India than outside, enough of a difference to stir smugglers to action and, with any further increases, the gold being transported through "unofficial" channels is likely to swell. Gold seizures at international borders reportedly tripled last year after the first two duty hikes.

To be sure, the government's efforts are having an impact - at least on the official trade statistics.

Demand fell from 970 tonnes in 2011 to an estimated 800 tonnes in 2012 and this total may sink even further in 2013, but that doesn't necessarily mean the Indian people will be buying any less gold - they'll just get more of it surreptitiously.

Ironically, since the new gold tax was first proposed in early-January, the rupee has strengthened about two percent, offsetting the duty hike that went into effect on January 21st. So, while gold buyers in India don't yet feel any of the effect of this latest duty increase aimed at curbing demand, at least the government can declare a partial victory.

Apparently, that's what passes for successful policy making in India these days.

The battle between the Reserve Bank of India and the Indian people over gold demand has heated over the last year as government economists have repeatedly ridiculed the obsession with the yellow metal and attempted to curtail it, despite its important role in the Indian culture.

Some 70 percent of Indian gold demand comes from rural areas where there is little or no access to banking or other financial services. For most of the population, it is easier to buy gold jewelry than to open a bank account and it's been that way for a very long time.

As a result, long ago, hundreds of millions in India turned to gold jewelry as a form of savings and investment, an investment that changes hands during the 10 million weddings each year and that has done remarkably well over the last decade as other asset classes have faltered.

If rural Indians did have access to banking services, they'd find that the government's stewardship of the economy and its paper money have left them no alternatives that are better than gold insofar as savings and investment are concerned.

The Reserve Bank of India just lowered its key interest rate from 8 percent to 7.75 percent this week, but, with inflation running at over 7 percent, there is little in the way of real yield even if rural Indians could open a bank account which, importantly, would come with just $2,000 in deposit insurance.

Inflation has been high in India for years and that's a key factor behind growing gold demand. One could argue that if the government didn't have an inflation problem, it wouldn't have a gold problem, and that's one important way that policy makers are addressing a symptom rather than a cause.

Over time, the Indian people have managed to accumulate over 20,000 tonnes of gold in jewelry, bar, and coin form, almost three times the amount of gold held by the Federal Reserve, the world's largest gold holder.

So far, it's working out pretty well for them, particularly in recent years as governments and central banks around the world have been on a credit, debt, and money printing binge as they lurch from one crisis to another.

High gold imports are a symptom of other problems in the Indian economy such as weak exports as companies lose competitiveness. In today's world of freely floating paper money, a weaker currency is part of the cure for trade deficits as it makes exported goods cheaper overseas. Since 2008, the rupee has fallen about 25 percent against the U.S. dollar, yet there's been no corresponding boost to exports.

The real problem is not gold, it's the stewardship of the national currency by the Indian government and how they've managed the economy.

Owners of exchange traded gold funds such as the SPDR Gold Shares ETF (NYSEARCA:GLD) and the iShares Gold Trust (NYSEARCA:IAU) are wisely betting on the Indian people to be right about gold, not their government.

Source: The Indian Government's Misguided Effort To Curb Gold Demand

Additional disclosure: I also own gold coins.