The relationship between the British Pound (GBP) and the Euro (EUR) has been significantly shaped by the United Kingdom’s departure from the European Union. As we entered 2021, the pound stood noticeably weaker against the euro, approximately 15% lower than its value before the 2016 Brexit referendum. This devaluation becomes even more pronounced when compared to the period preceding the referendum act in December 2015, revealing a 20% decrease. Over the past half-decade, Brexit has emerged as a dominant factor influencing the exchange rate volatility and the overall value of the pound relative to major global currencies, especially the euro.
The immediate aftermath of the referendum vividly illustrated Brexit’s impact, with sterling enduring its most dramatic single-day plunge in three decades. This initial shockwave was followed by further substantial and sustained declines in 2017 and 2019, culminating in the pound reaching new lows against both the euro and the US dollar by August 2019. These fluctuations underscore the profound effect of political and economic shifts on currency values in the global market.
This depreciation was largely fueled by anticipations of increased trade barriers between the UK and the EU, its most significant trading partner. Coupled with escalating uncertainty and persistent political instability, these factors prompted financial institutions to divest from the pound. As organizations increasingly sold off assets denominated in sterling, the currency’s value diminished in comparison to others, most notably the euro. To truly grasp these shifts in the Currency Gbp Vs Euro dynamic, it’s crucial to understand the fundamental mechanisms that drive exchange rate changes.
Decoding Exchange Rate Shifts: Supply and Demand in Currency Markets
An exchange rate, at its core, is simply the price of one currency expressed in terms of another. Like any price in a market economy, it is governed by the principles of supply and demand. In the context of currency exchange, this means that the value of one currency will appreciate (increase) while the other depreciates (decreases) as market participants increase their demand for the former and sell off the latter.
In the case of the pound’s post-referendum depreciation against the euro, this reflects a fundamental decrease in the demand to hold pounds relative to euros. Therefore, to fully comprehend the Brexit-related exchange rate movements and the currency gbp vs euro relationship, we must delve into the factors that influence the demand for a currency in the global market.
Key Players in Currency Exchange: Beyond Trade in Goods and Services
Organizations engaged in international trade, dealing with goods and services, are indeed significant participants in currency markets. This includes multinational corporations involved in cross-border sales and individual travelers exchanging currencies for personal spending. For instance, when a UK entity or individual purchases goods from the United States, they need to convert pounds into dollars, thereby increasing the demand for dollars. Significant shifts in international trade volumes can, therefore, impact the demand for and value of a currency.
However, the rapid and substantial weakening of the pound since 2016 occurred even before any tangible changes in the trading relationship between the UK and the EU had materialized. Moreover, the volume of trade in goods and services does not constitute the primary source of overall foreign exchange transactions and typically does not exhibit sharp fluctuations in the short term, according to the Bank for International Settlements (BIS). This suggests that changes in the trade of goods and services might not be the primary catalyst behind the extreme exchange rate volatility observed and may not be the principal reason for the Brexit-induced fall in the currency gbp vs euro exchange rate.
A more critical factor driving the sharp declines in the pound’s value since 2016 is the substantial reduction in the inclination of financial institutions to hold investments denominated in pounds. The trading of currencies for investment purposes, or the trade in financial assets, constitutes the largest proportion of currency transactions and is generally the most potent driver of exchange rate fluctuations, particularly in the short run.
This type of capital movement is often referred to as ‘hot money’ – funds that are highly mobile and can be swiftly transferred between investments or currencies on a massive scale, causing rapid shifts in exchange rates. Consequently, the most influential participants in currency markets are financial institutions, including major banks, securities firms, and institutional investors.
In 2019, financial institutions (excluding foreign exchange dealers) accounted for a staggering 57.8% of foreign exchange turnover in the UK. In stark contrast, only 4.9% of currency exchange volume was directly attributable to non-financial customers, as per BIS data.
Furthermore, the UK’s persistent trade deficit, where imports consistently outweigh exports, exacerbates its reliance on international capital inflows. This makes the pound more susceptible to the ebb and flow of international capital movements. The current account deficit has been increasingly financed by these capital inflows, amplifying the pound’s vulnerability in the currency gbp vs euro and broader global markets.
Brexit’s Impact on Investor Confidence: Why the Pound Became Less Appealing
The primary considerations for financial institutions operating in currency markets are factors that influence the returns on investments in different currencies. Consequently, the Brexit-related devaluation of the pound indicates that financial market participants anticipated that investments in assets denominated in pounds would perform less favorably after the Brexit vote than they would have otherwise.
Numerous factors can potentially affect returns in currency markets, making it challenging to isolate the individual effects. Nevertheless, some of the most prominent factors typically include shifts in relative interest rates, changes in perceived risk, and evolving overall investor expectations.
Interest Rate Dynamics and Currency Valuation
Changes in interest rates, or factors influencing interest rates, are widely recognized as significant drivers of exchange rates. This is because domestic interest rates can alter the relative attractiveness of assets in different countries. A reduction in interest rates within a country means that assets linked to that rate will yield a lower return. An unexpected decrease in interest rates, assuming other factors remain constant, will lead to a decrease in demand for those assets compared to similar assets denominated in other currencies. This, in turn, will cause a depreciation in the value of the currency in question.
For instance, in response to the Leave vote, the Bank of England reduced interest rates in August 2016 from 0.5% to 0.25% and expanded its program of ‘quantitative easing’ (QE). However, it’s important to note that this policy adjustment was announced weeks after the Brexit vote. Therefore, the substantial initial drop in the pound’s value in June 2016, and subsequent declines in later years, cannot be solely attributed to the immediate reaction of financial market participants to this specific interest rate policy change.
Uncertainty, Political Instability, and Risk Perception
Changes in risk perception can also significantly impact expected returns and influence investors’ decisions regarding which assets, including currencies, to hold. Heightened uncertainty surrounding factors such as future company performance, economic forecasts, interest rate trajectories, and political stability can make holding assets in a particular currency riskier, leading to reduced or delayed investment inflows.
The increased likelihood of greater trade friction between the UK and the EU post-Brexit amplified these risks for assets denominated in pounds. Research conducted prior to the referendum had predicted substantial decreases in foreign investment in the UK as a consequence of Brexit-related trade costs.
These risks were further compounded by significant and persistent political instability in the UK, which prolonged and deepened the uncertainty surrounding post-Brexit trading arrangements and the anticipated economic outcomes. The most substantial and sustained declines in the pound’s value since 2016 were closely correlated with periods of heightened uncertainty and associated political turmoil.
Notably, one of the most significant drops in sterling’s value against the euro occurred in 2017, following an early general election that resulted in a hung parliament. In 2019, the pound plummeted to a new multi-year low against both the dollar and the euro shortly after Boris Johnson assumed office as Prime Minister and indicated a willingness to consider a ‘no-deal’ Brexit – widely perceived as the most adverse potential economic scenario for the UK.
Evidence suggests that the negative repercussions of this uncertainty on employment, productivity, and investment within UK businesses became increasingly apparent in the years immediately following the referendum.
The Power of Expectations in Currency Markets
The depreciation of the pound largely preceded the actual implementation of Brexit. Conversely, exchange rate movements were relatively muted when the UK officially left the EU and the transition period concluded at the end of 2020. This is because investor expectations serve as a crucial trigger that helps explain the timing of currency movements.
Shifting investor expectations are rapidly incorporated into currency markets due to the sheer volume and speed of trading activity. Any new information that affects expectations regarding a currency will be swiftly reflected in exchange rates. If market participants anticipate a negative future impact on investments denominated in a particular currency, they will sell off that currency, causing its value to decline.
The record-breaking fall of the pound immediately after the referendum underscores the rapid impact of evolving market expectations on currencies, as the Leave vote outcome surprised many observers. Last-minute polls had suggested a likely victory for the Remain campaign, which initially caused sterling to appreciate in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately following the result highlights the negative expectations that financial market participants harbored for sterling investments once the outcome became clear.
The significant declines in the pound in 2017 and 2019 occurred during periods of heightened political uncertainty. These declines also reflect increasingly pessimistic expectations for sterling-denominated investments, driven by the growing probability of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade agreement preceded appreciations in the pound’s value.
Recent research has demonstrated specific links between economic policy uncertainty and exchange rate expectations. Findings indicate that market participants factor in the level of policy uncertainty when formulating their expectations, directly influencing currency gbp vs euro valuations and other exchange rates.
The Economic Consequences of a Weaker Pound
One immediate consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK residents. This directly translates to increased levels of inflation and a higher cost of living for consumers.
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 residents of other countries. This, in turn, can potentially have positive effects on the country’s trade deficit and overall economic growth.
Research examining the net effect of currency depreciation is, at best, inconclusive. Furthermore, lingering uncertainty surrounding the magnitude and implications of post-Brexit trade frictions makes the long-term economic outlook for the UK even more ambiguous. To fully understand the longer-term consequences of the Brexit-related depreciation of the pound and its impact on the currency gbp vs euro dynamic and the broader UK economy, further in-depth research is essential.
Expert Perspectives
To gain a deeper understanding of currency dynamics and the factors influencing the GBP vs EUR exchange rate, consulting with experts in the field is invaluable. Leading economists specializing in exchange rates and international finance include:
- 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)
Author: Christopher Coyle
