Since the dawn of 2021, the British pound has seen a significant shift in its value against the euro. It sits approximately 15% weaker compared to its standing right before the 2016 referendum on the UK’s European Union membership. Looking further back, the pound’s position is even more pronounced, being 20% weaker than when the EU Referendum Act was enacted in December 2015. This dramatic shift underscores the profound impact of Brexit on the Currency Pound Euro exchange rate dynamics.
Over the past half-decade, Brexit has emerged as a central force shaping the volatility and valuation of the pound against major global currencies. The immediate aftermath of the referendum vote vividly illustrated this influence, as sterling plummeted, marking its most substantial single-day drop in three decades. Further significant and sustained declines followed in 2017 and 2019, pushing the pound to unprecedented lows against both the euro and the US dollar by August 2019, as depicted in Figure 1. This figure illustrates the daily currency pound euro exchange rate from 2015 to 2021, highlighting the periods of significant fluctuation.
This depreciation was largely fueled by growing anticipation of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and persistent political instability. These factors led financial institutions to divest from the pound. As organizations increasingly sold assets denominated in sterling, the value of the pound diminished relative to other currencies, significantly impacting the currency pound euro exchange rate and broader financial markets.
Understanding Exchange Rate Dynamics
An exchange rate, at its core, is simply the price of one currency expressed in terms of another. These rates are not static; they fluctuate based on the fundamental principles of supply and demand. In any currency pair, one currency will appreciate (increase in value) while the other depreciates (decrease in value) depending on market activity – when there’s increased buying pressure on one and selling pressure on the other.
The post-referendum decline in the pound’s value fundamentally reflects a decrease in the demand to hold pounds compared to other currencies. To grasp the underlying reasons for Brexit-related exchange rate movements, particularly concerning the currency pound euro relationship, it’s crucial to identify the factors that drive the demand for a currency in the global market.
The Key Players in Exchange Rate Fluctuations
Participants in international trade, dealing with goods and services, are naturally significant actors in currency markets. This includes multinational corporations engaged in cross-border sales and individual travelers exchanging currency for personal expenditures. For instance, when a UK entity or individual purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars and influencing the currency pound euro dynamic indirectly through dollar strength. Major shifts in international trade patterns can indeed alter currency demand and valuation.
However, the rapid and substantial depreciation of the pound since 2016 occurred before any tangible changes in the trade relationship between the UK and the EU had materialized. Moreover, trade in goods and services isn’t the predominant factor in overall foreign exchange transactions, and it doesn’t typically exhibit sharp short-term changes (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade are not the primary driver of the extreme exchange rate volatility observed and might not be the main cause of the Brexit-linked decline in the pound’s value when considering the currency pound euro exchange rate.
A critical factor behind the sharp falls in the pound’s value since 2016 is a significant reduction in the inclination of financial institutions to hold investments denominated in pounds. Currency trading for investment purposes, or the trade of financial assets, constitutes the largest portion of currency transactions and is generally the most significant driver of exchange rate movements, especially in the short term. This is particularly relevant when analyzing the currency pound euro exchange rate.
This type of capital flow is often termed ‘hot money’ – funds that are highly mobile and can swiftly move between investments or currencies on a large scale, rapidly impacting exchange rates. Consequently, the most influential players in currency markets are financial institutions such as banks, securities firms, and institutional investors, whose decisions significantly sway the currency pound euro rate.
In 2019, financial institutions (excluding foreign exchange dealers) accounted for 57.8% of foreign exchange turnover in the UK. In contrast, only 4.9% of currency exchange volume was directly attributed to non-financial customers (BIS, 2019). These figures highlight the dominant role of financial institutions in shaping exchange rates, including the currency pound euro rate.
Furthermore, the UK’s persistent trade deficit, where imports exceed exports, leads to a reliance on external financing and makes the pound more susceptible to international capital movements. This is because the current account deficit has been increasingly financed by these capital inflows, making the currency pound euro relationship more vulnerable to shifts in global investment sentiment.
Brexit’s Impact on the Pound’s Attractiveness
Financial institutions, as key drivers in currency markets, primarily respond to factors influencing the returns on investments across different currencies. The Brexit-related depreciation of the pound suggests that financial market participants anticipated poorer performance from investments in pound-denominated assets following the Brexit vote than would have otherwise been expected. This anticipation significantly impacted the currency pound euro exchange rate.
Numerous factors can potentially influence returns in currency markets, and isolating the individual effects is complex. However, some of the most crucial factors typically include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations. These elements are particularly pertinent when examining the currency pound euro exchange rate.
Interest Rates and Currency Value
Changes in interest rates, or factors affecting them, are widely recognized as primary drivers of exchange rates. This is because domestic interest rates can alter the relative attractiveness of assets in different countries. A decrease in a country’s interest rates reduces the returns on assets linked to that rate. An unexpected interest rate cut, assuming other factors remain constant, typically leads to a decline in demand for those assets relative to assets in currencies offering higher returns. This, in turn, causes a depreciation of the currency in question, affecting the currency pound euro balance.
For example, in response to the Leave vote, the Bank of England lowered interest rates in August 2016 from 0.5% to 0.25% and expanded its quantitative easing (QE) program. However, it’s important to note that this policy change was announced weeks after the Brexit vote. Therefore, the sharp initial fall in the pound’s value in June 2016, or subsequent declines in later years, cannot be solely attributed to the immediate reaction of financial markets to this specific interest rate adjustment. Other factors related to Brexit’s broader implications were more immediately impactful on the currency pound euro rate.
Uncertainty, Political Instability, and Risk Perception
Changes in risk perception can also significantly affect expected returns and influence investor decisions regarding asset and currency holdings. Increased uncertainty surrounding factors such as future company performance, economic forecasts, interest rate trajectories, and political stability can make holding assets in a specific currency riskier. This increased risk can deter or delay investment inflows, negatively impacting the currency pound euro exchange rate and overall currency valuation.
The heightened probability of increased trade frictions between the UK and the EU post-Brexit amplified these risks for assets denominated in pounds. Pre-referendum research had predicted substantial decreases in foreign investment in the UK due to Brexit-related trade costs. These predictions began to materialize and exert downward pressure on the currency pound euro rate.
These risks were further compounded by significant and persistent political instability in the UK. This prolonged and deepened the uncertainty surrounding post-Brexit trade relationships and the anticipated economic outcomes. The most substantial and sustained falls in the pound since 2016 were closely correlated with periods of heightened uncertainty and associated political turmoil, directly impacting the currency pound euro value.
One of the most significant depreciations of sterling against the euro occurred in 2017, following an early general election that resulted in a hung parliament. In 2019, the pound reached a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister, particularly due to his stance on not ruling out a no-deal Brexit. A no-deal Brexit was widely considered the worst-case economic scenario for the UK, further destabilizing the currency pound euro exchange rate.
Evidence suggests that the negative consequences of this uncertainty on employment, productivity, and investment in UK businesses became increasingly apparent in the years immediately following the referendum. This economic uncertainty further eroded investor confidence in the pound, contributing to its weakened position against the euro.
The Role of Investor Expectations
The depreciation of the pound largely occurred before Brexit officially took place. In contrast, exchange rate movements were relatively subdued when the UK formally left the EU and the transition period concluded at the end of 2020. This timing is crucial and highlights the significant role of investor expectations in currency markets. Investors’ anticipations are a key trigger in explaining the timing of currency movements.
Due to the immense volume and speed of trading in currency markets, changing investor expectations are rapidly incorporated into exchange rates. Any new information that influences expectations about a currency’s future performance will swiftly be reflected in its exchange rate. If market participants anticipate negative future impacts on investments in a particular currency, they will sell that currency, causing its value to fall, impacting pairings like the currency pound euro rate.
The record fall of the pound immediately after the referendum exemplifies the rapid impact of shifting market expectations on currencies. The Leave vote surprised many commentators, as last-minute polls suggested a likely Remain victory, which had initially caused sterling to appreciate in the days leading up to the referendum. The collapse in the pound’s value immediately after the result announcement underscores the negative expectations financial market participants held for sterling investments once the outcome was clear. This shift in expectation dramatically altered the currency pound euro exchange rate.
The substantial falls in the pound during 2017 and 2019, during periods of heightened political uncertainty, also reflect increasingly negative expectations for sterling-denominated investments. These negative expectations were driven by the growing likelihood of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and the possibility of a trade deal led to increases in the pound’s value, demonstrating the powerful influence of expectations on the currency pound euro rate.
Recent research has established specific links between economic policy uncertainty and exchange rate expectations, confirming that market participants factor in the level of policy uncertainty when forming their expectations about currency values. This directly impacts the currency pound euro exchange rate as well as other currency pairings.
Consequences of a Weaker Pound
One immediate consequence of a weaker pound is that goods, services, and assets originating from foreign countries become more expensive for UK residents. This leads to increased inflation and a higher cost of living for individuals within the UK. The impact is felt across various sectors, from imported goods to international travel, all due to the shift in the currency pound euro and other exchange rates.
However, a weaker currency can also offer potential benefits. It can enhance export competitiveness by reducing the cost of domestically produced goods and services for buyers in other countries. This can potentially lead to positive outcomes for the country’s trade deficit and overall economic growth, as UK goods become more attractive in international markets due to the favorable currency pound euro exchange rate.
Research on the net effect of currency depreciation is, at best, mixed. Furthermore, ongoing uncertainty surrounding the extent and implications of post-Brexit trade frictions complicates the outlook for the UK economy. This uncertainty makes it difficult to predict the long-term consequences of the Brexit-related fall in sterling. To fully understand the longer-term impacts of the currency pound euro depreciation and related economic shifts, further in-depth research is necessary.
Experts in the Field:
- Mark P. Taylor (Washington University)
- Ronald MacDonald (University of Glasgow)
- Keith Pilbeam (City, University of London)
- Jeffrey Frankel (Harvard University)
- Christopher Coyle (Queen’s University Belfast)
