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For the last year, the Indian financial authorities have been waging an unofficial war on gold, which has only intensified over the last few months as the Indian government has raised the tax on gold imports. Since India is the second largest gold market in the world, anything that happens in the Indian gold market needs to be followed by gold and gold ETF investors (GLD, PHYS, and CEF).

As Bloomberg reports, the government raised the import duty to 8 percent from 6 percent on June 5, a fourfold increase from January last year. The central bank has also placed restrictions on overseas purchases on a consignment basis and limited imports for local consumption against cash only. The curbs will change the financial models of jewelers in the country, said Bhaskar Bhat, managing director of Titan Industries Ltd. (TTAN) Shares of Titan and other jewelers have slumped in Mumbai this week on concern rising import costs may hurt their profit margins.

"The intention of the government is that imports have to be curbed and it has begun to work," said Bhat, whose Titan is the nation's biggest jeweler by value. "In the last seven or eight days, imports have come down significantly."

The primary reason given by the government for these restrictions is that the current account deficit [CAD] for the country is too high. India has had a CAD for quite a while now, but what is causing the alarm for the financial minister is that the Indian Rupee is weakening and dropping to all-time lows versus the U.S. dollar. They need to do something to stem the fall of the Rupee, and since they can neither raise interest rates (the economy is too fragile) nor cut oil imports; they have chosen to cut on gold imports.

We are seeing a large drop in official gold imports to India, but as with any government policy meant to curb free market demand, there are unintended consequences.

The first unintended consequence we are seeing is that gold imports to India through unofficial channels have been increasing. Obviously, we would not be able to quantify these amounts, but customs has been reporting a surge in illegal gold imports that have been confiscated, which means that there is probably quite a lot of imports that are not being caught.

This is going to lead to a large loss in tax revenues as gold that is ordinarily taxed is no longer going to generate that revenue for the government since it will be coming in illegally. Additionally, depending on the amount of gold imported through unofficial channels, this policy may not even solve the CAD problems experienced by the government because rupees will still be exchanged for other currencies to buy gold - it just will not be registered with government officials. One of the things investors should do is to keep an eye on the rupee-dollar exchange rate, if it continues to weaken that may be a sign that government policies are not working and large amounts of gold are still entering India through illegal imports.

The second unintended consequence is related to Indian exports of gold. As a result of the tight gold supply picture in India due to increased import taxes, Indian exports of gold have plummeted.

As investors can see, in May gold exports dropped by almost 14 tonnes of gold year-over-year, while in June they dropped by 24 tonnes of gold year-over-year. This is a significant drop and is equivalent to over twice the amount of gold reserves held by the government of Cyprus - per month!

What this means in economic terms, is that gold that ordinarily would be leaving India for the Middle East, Europe, and even the US will no longer be exported to these countries. That gold will have to come from elsewhere, which will put even more stress on the physical gold market.

What this Means for Gold Investors

Investors in physical gold and the gold ETFs (GLD, PHYS, and CEF) should look at this as very positive news. The Indian government's attack on gold by raising import duties has been well documented in the press, but the unintended consequences of this action may further hurt the rupee and are definitely changing the dynamics of the gold supply and demand picture.

India's export of 24 tonnes less of gold in June 2013 versus June 2012, equate to around 280 tonnes over the year - or over 10% of world gold mine supply. That is a huge amount of gold that ordinarily would be entering other markets that is no longer available. This may be one of the many reasons contributing to the negative gold borrowing rates - as a sign of stress in the physical gold market. It may just be the physical market will once again drive the paper market gold price and gold investors should add this amongst the positive catalysts in gold's favor.

Source: India's Gold Exports Slump: The Government's Unintended Consequences