India fulfils most of its gold demand through imports, which were putting pressure on the rupee INR=IN that hit a record low earlier on Friday.
The duty hike would lift prices and moderate demand in India, which could weigh on global prices XAU=. But it could stoke under-the-counter buying and drive-up appetite for precious metal smuggled into the country, trade officials said.
"The sudden rise in prices could bring down jewellery demand this month," said Prithviraj Kothari, managing director of RiddiSiddhi Bullions.
After the duty hike, dealers were offering a discount of up to $40 an ounce over official domestic prices — inclusive of the 12.5% import and 3% sales levies.
India's May trade deficit widened to $24.29 billion from $6.53 billion a year ago as gold imports in the month surged to $6 billion from 678 million a year ago.
In the short-term gold demand could fall but in the long run demand would remain strong and imports would rebound, said Surendra Mehta, secretary at the India Bullion and Jewellers Association (IBJA).
After the duty announcement, local gold prices MAUc1 rose around 3%, while global prices fell 0.5%.
The hike has raised the gap between local and overseas prices to more than 15% and this could boost smuggling of gold in the country, said a Mumbai-based dealer with a global trading firm.
"Smuggling was falling after the duty reduction and because of COVID-19 curbs on movement of people. But now it could rise again," the dealer said.
Shares of jewellery makers such as Titan TITN.NS Kalyan Jewellers KALN.NS and Tribhovandas Bhimji Zaveri TBZL.NS were down as much as 4% in weak Mumbai market .NSEI.