Since the UK’s vote to leave the European Union in June 2016, the exchange rate between the English pound (GBP) and the euro (EUR) has experienced significant volatility. At the beginning of 2021, the pound was considerably weaker against the euro compared to its position before the Brexit referendum. This article delves into the key factors influencing the Exchange Rate English Pound To Euro over the past years, particularly in the context of Brexit, providing a comprehensive understanding for those tracking currency movements and their economic implications.
The impact of Brexit has undeniably been a primary driver in the fluctuations of the pound against major currencies, most notably the euro. Immediately following the 2016 referendum result, the pound sterling saw its most dramatic single-day drop in three decades. This initial shockwave was followed by further periods of sustained decline in 2017 and 2019, pushing the pound to new lows against both the euro and the US dollar.
Figure 1: Daily fluctuations in the Pound to Euro exchange rate from 2015 to 2021, illustrating the volatility around key Brexit events.
These declines were largely triggered by the anticipation of increased trade barriers between the UK and the EU, its largest trading partner. The uncertainty and political instability that followed the referendum led financial institutions to reduce their holdings in pound-denominated assets, selling off sterling and consequently driving down its value relative to the euro and other currencies.
The Mechanics of Exchange Rate Shifts
To understand why the exchange rate English pound to euro changes, it’s essential to grasp the fundamental principles governing exchange rates. An exchange rate is essentially the price of one currency in terms of another. Like any price, it is determined by the forces of supply and demand. When demand for a particular currency increases, its value appreciates, while the currency it is paired against depreciates.
The weakening of the pound since the Brexit referendum indicates a decrease in the global demand to hold pounds relative to other currencies, including the euro. To fully comprehend the Brexit-related shifts in the exchange rate English pound to euro, we need to examine the factors that influence the demand for a currency in the international market.
Key Players in Currency Exchange Markets
Participants in international trade, dealing with goods and services across borders, play a significant role in currency markets. This includes multinational corporations, import/export businesses, and even individual travelers exchanging currency for tourism or business trips. For instance, when a UK company imports goods from a Eurozone country, it needs to convert pounds into euros, thereby increasing the demand for euros and potentially affecting the exchange rate English pound to euro.
However, the rapid and substantial depreciation of the pound following the 2016 referendum occurred before any actual changes to the UK-EU trading relationship were implemented. Furthermore, trade in goods and services isn’t the primary driver of overall foreign exchange transactions, nor does it typically fluctuate dramatically in the short term, according to the Bank for International Settlements (BIS). This suggests that changes in the trade of goods and services alone may not fully explain the extreme volatility observed in the exchange rate English pound to euro in the wake of Brexit.
A more critical factor behind the sharp falls in the pound’s value is the significant reduction in the willingness of financial institutions to hold investments denominated in pounds. The trading of currencies for investment purposes, or the trade in financial assets, constitutes the majority of currency transactions and is often the most significant driver of exchange rate fluctuations, particularly in the short run.
This type of capital movement is often referred to as ‘hot money’ – highly mobile capital that can be rapidly shifted between investments or currencies, exerting immediate and substantial pressure on exchange rates. Consequently, the most influential participants in currency markets are large financial institutions, such as banks, investment 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, while transactions directly attributable to non-financial customers represented a mere 4.9% of the total volume (BIS, 2019).
Adding to the pound’s vulnerability is the UK’s persistent current account deficit, where imports consistently exceed exports. This deficit necessitates reliance on international capital inflows to balance the books, making the pound more susceptible to the ebbs and flows of global capital movements and thus impacting the exchange rate English pound to euro.
Brexit’s Negative Impact on Pound Sterling’s Appeal
Financial institutions, as key drivers in currency markets, primarily react to factors that influence the expected returns on investments in different currencies. The decline in the exchange rate English pound to euro associated with Brexit strongly suggests that financial market participants perceived investments in pound-denominated assets as less attractive after the referendum vote.
Several factors can influence returns in currency markets, and isolating the impact of each is complex. However, key determinants typically include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations.
Interest Rate Dynamics
Interest rates and their anticipated changes are widely recognized as significant drivers of exchange rates. Domestic interest rates affect the relative attractiveness of assets in different countries. Lower interest rates in a country reduce the returns on assets linked to that rate. An unexpected decrease in interest rates, all else being equal, leads to a decrease in demand for those assets compared to assets in currencies with higher returns. This, in turn, causes a depreciation in the value of the currency.
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, this policy change occurred weeks after the initial Brexit vote. Therefore, while interest rate adjustments play a role in exchange rate dynamics, the immediate and sharp fall in the exchange rate English pound to euro in June 2016 cannot be solely attributed to this specific interest rate cut.
The Role of Uncertainty and Political Instability
Perceptions of risk are another crucial factor influencing expected returns and, consequently, investor decisions about currency holdings. Increased uncertainty surrounding factors like future economic performance, company profitability, interest rate trajectories, and political stability can heighten the risk associated with holding assets in a specific currency. This increased risk can lead to reduced or delayed investment inflows.
The heightened probability of increased trade frictions between the UK and the EU post-Brexit significantly amplified these risks for pound-denominated assets. Pre-referendum research anticipated substantial declines in foreign investment in the UK due to 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 future trading relationships and the overall economic outlook. The most pronounced and sustained falls in the exchange rate English pound to euro since 2016 have been closely linked to periods of heightened uncertainty and political turmoil.
For instance, one of the most significant drops in sterling against the euro occurred in 2017, following a snap general election that resulted in a hung parliament. Similarly, in 2019, the pound plummeted to multi-year lows against both the dollar and the euro shortly after Boris Johnson became Prime Minister, particularly due to concerns over a potential ‘no-deal’ Brexit – widely considered the most damaging economic scenario for the UK.
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.
Investor Expectations and Market Sentiment
The depreciation of the pound largely occurred before Brexit actually materialized. 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 highlights the critical role of investor expectations in driving currency movements.
Due to the immense volume and speed of transactions in currency markets, changing investor expectations are rapidly incorporated into exchange rates. Any new information that alters expectations about a currency’s future prospects will quickly be reflected in its exchange rate. If market participants anticipate a negative future impact on investments in a currency, they will sell that currency, causing its value to decline.
The record fall in the pound immediately after the referendum illustrates the rapid impact of shifting market expectations. The Leave vote surprised many, as last-minute polls suggested a likely Remain victory, which had initially caused the pound to appreciate in the days leading up to the vote. The subsequent collapse in the pound’s value underscored the negative expectations financial market participants held for pound investments once the referendum outcome became clear.
Similarly, the significant falls in the exchange rate English pound to euro in 2017 and 2019 coincided with periods of heightened political uncertainty, reflecting 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 deal led to increases in the pound’s value.
Recent research has established specific links between economic policy uncertainty and exchange rate expectations, indicating that market participants factor in the level of policy uncertainty when forming their outlook.
Consequences of a Weaker Pound
A direct consequence of a weaker pound is that goods, services, and assets from countries using the euro become more expensive for UK residents. This translates to higher import costs, contributing to increased inflation and a higher cost of living in the UK.
However, a weaker currency can also offer potential benefits. It can make exports more competitive by lowering the cost of UK goods and services for buyers in Eurozone countries and elsewhere. This could potentially improve the UK’s trade deficit and contribute to overall economic growth.
Research on the net effect of currency depreciation is inconclusive, and the long-term consequences for the UK economy remain uncertain, particularly given the ongoing adjustments to post-Brexit trade relationships. Further research is needed to fully understand the lasting impacts of the Brexit-related weakening of the exchange rate English pound to euro.
Experts on Exchange Rates and Brexit Impacts:
- 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
Photo by PublicDomainPictures from Pixabay
