Approach

Introduction: Mention what FPI is and how it impacts the economy. Use a diagram to show the benefits of FPIs.

Body:

Heading 1: Risks: Enlist different challenges that come with FPI inflows.

Heading 2: Measures: Suggest measures with respective government initiatives.

Conclusion: Mention the importance of FPI as a tool for growing the economy along with the importance of measures required.

Answer:

Foreign portfolio investment (FPI) refers to the purchase of securities and other financial assets in India by investors from another country. They are regulated by SEBI and are part of a country's capital account, shown on its Balance of Payments (BoP).

Risks associated with FPIs:

• Currency risk: FPI inflows can impact exchange rates, affecting export competitiveness and the current account balance. 
• For example, in FY21, India experienced the highest ever FPI inflow, leading to an appreciation of the Indian rupee and making exports costlier for foreign buyers.
• Asset price inflation: FPI inflow, especially in real estate and stock markets, can lead to economic distortions, diversion of resources, and overinvestment in these sectors. 
• For example, record-high FPI inflows in FY21 caused BSE Sensex to cross the 50,000 mark for the first time, which was not necessarily aligned with the underlying economic fundamentals, as the Indian economy was still reeling from the impact of the pandemic.
• Volatility risk: Countries with large FPI investments are most impacted by rapid capital outflows due to sudden changes in investors' sentiment. 
• For example, FPIs pulled out a net investment of ₹1.40-lakh crore in FY22, owing to the pandemic and Fed rate hike.
• Potential contagion effects: FPI outflow episodes can create instability in one market that spreads to other markets, leading to a broader economic crisis. 
• For example, Southeast Asian countries' crisis of the 1990s had a huge contagion effect because of the volatility of 'hot money,' including FPIs (RBI report on FPIs).

Measures Required

• Monetary measures: The RBI takes various steps to counter exchange rate volatility during FPI inflows, such as accumulating forex reserves and limiting investments by FPIs in short-term debts. 
• For example, during FY 2020-21, RBI net purchased $68.315 billion to counter excessive appreciation of the rupee.
• Diversification of the economy: Promoting investment in sectors that are less vulnerable to FPI inflows can help reduce the impact on the domestic economy.
• For example, manufacturing (Make in India) and agriculture sectors, 
• Fiscal and regulatory measures: Government policies related to taxation, administration, and regulation play a crucial role. 
• For example, the Tobin tax, Mutual Legal Assistance Treaties (MLATs), Double Taxation Avoidance Agreements (DTAA), etc.
• Developing domestic financial markets: Enhancing the investor base, increasing domestic savings to reduce reliance on foreign capital, improving corporate governance, and transparency to prevent capital flight are essential. 
• For example, initiatives like PMJDY and APY promote domestic savings, while the Insolvency and Bankruptcy Code boosts investors' confidence.
• Other measures: These include currency swaps, internationalization of the rupee, better risk management, and policy pushes for the deepening of debt markets. These measures contribute to a more stable environment for FPI inflows.

FPI inflows provide vital capital for developing economies, but policy caution and mitigation measures are necessary to avoid negative impacts. Striking a balance between foreign investment and macroeconomic stability is crucial for sustainable growth.