The journey of the British Pound (GBP) against the Euro (EUR) has been significantly shaped by Brexit. As we stepped into 2021, the pound’s value was noticeably weaker against the euro – approximately 15% lower than its standing before the 2016 referendum on the UK’s EU membership. This depreciation becomes even more pronounced when compared to December 2015, when the EU Referendum Act received Royal Assent, revealing a 20% decrease.
Brexit has undeniably emerged as a pivotal force influencing the volatility of exchange rates and the pound’s valuation against major global currencies over the past half-decade. The immediate aftermath of the referendum vote vividly illustrated this impact, as Sterling endured its most significant single-day plunge in three decades. Further substantial and persistent declines occurred in 2017 and 2019, pushing the pound to new lows against both the euro and the dollar by August 2019, as depicted in Figure 1.
This devaluation largely stemmed from growing expectations of increased trade barriers between the UK and its primary trading partner. Coupled with heightened uncertainty and ongoing political instability, these factors prompted financial institutions to divest from the pound. As organizations increasingly sold assets denominated in Sterling, the pound’s value diminished relative to other currencies.
Figure 1: Daily fluctuations in the Pound/Euro exchange rate from 2015 to 2021, highlighting the impact of Brexit.
Understanding exchange rate dynamics requires grasping the fundamental principles at play.
Decoding Exchange Rate Shifts
An exchange rate represents the price of one currency in relation to another. These rates are not static; they fluctuate based on the fundamental principles of supply and demand. In any currency pair, when demand for one currency increases while the other is sold off, the former appreciates in value, and the latter depreciates.
Essentially, the post-referendum decline in Sterling’s value indicates a reduced demand for holding pounds compared to other currencies. To fully comprehend the underlying reasons for these Brexit-induced exchange rate movements, we must delve into the factors that govern currency demand.
Key Players in Exchange Rate Dynamics
Participants in the international trade of goods and services play a familiar and crucial role in currency markets. This encompasses businesses engaged in cross-border trade and individual travelers exchanging currencies for personal expenditures. For instance, when a UK resident or company imports goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars. Significant shifts in international trade volumes can thus influence currency demand and valuation.
However, the rapid and substantial depreciation of Sterling since 2016 preceded any actual alterations in the trading relationship between the UK and the EU. Moreover, the volume of trade in goods and services is not the primary driver of overall foreign exchange transactions and typically doesn’t experience sharp short-term fluctuations (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade may not be the principal cause of extreme exchange rate fluctuations and might not fully explain the Brexit-related decline in Sterling’s value.
A critical factor behind the sharp falls in the pound’s value since 2016 is the significant decrease in financial institutions’ preference to hold investments denominated in pounds. Currency trading for investment purposes, or financial asset trading, constitutes the largest segment of currency transactions and is typically the most significant driver of exchange rate changes, particularly in the short term.
This is often referred to as ‘hot money’ – capital that is highly mobile and can swiftly move between investments or currencies on a large scale, rapidly impacting exchange rates. Consequently, major and influential players in currency markets are financial institutions such as banks, securities firms, and institutional investors.
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).
Adding to the pound’s vulnerability, the UK’s persistent trade deficit, where imports consistently exceed exports, creates a reliance on external financing. This current account deficit makes the pound more susceptible to international capital flows because it has become increasingly funded by these inflows, echoing concerns about the UK relying on the ‘kindness of strangers’.
Brexit’s Impact on Pound Sterling’s Appeal
The primary factors influencing financial institutions’ decisions in currency markets are those affecting the returns on investments in different currencies. The Brexit-related depreciation of Sterling suggests that financial market participants anticipated that investments in pound-denominated assets would perform less favorably post-Brexit than they would have otherwise.
Numerous factors can potentially influence returns in currency markets, making it challenging to isolate individual effects. However, key factors typically include shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.
Interest Rates
Interest rate adjustments, or factors influencing interest rates, are widely considered major drivers of exchange rates. This is because domestic interest rates can impact 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) will lead to decreased demand for those assets compared to equivalent assets in other currencies, causing a fall in the value of the currency in question.
For example, following 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 significant pound devaluation in June 2016, or in subsequent years, cannot be solely attributed to financial market participants’ reaction to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in risk perception also impact expected returns and influence investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors like future company performance, economic outlook, interest rates, and political stability can elevate the risk associated with holding assets in a specific currency. This can lead to reduced or delayed investment flows (Pindyck, 1991).
The heightened probability of increased trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Pre-referendum research predicted substantial declines in foreign investment in the UK due to Brexit-related trade costs (Dhingra et al, 2016).
These risks were further compounded by significant and persistent political instability in the UK. This prolonged and deepened uncertainty surrounding post-Brexit trading relationships and the anticipated economic consequences. The most substantial and sustained pound depreciations since 2016 were closely linked to heightened uncertainty and associated political turmoil.
One of the most significant Sterling value drops against the euro occurred in 2017, following an early general election that resulted in a hung parliament. In 2019, the pound fell to a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister. His refusal to dismiss a ‘no-deal’ Brexit scenario – widely considered the worst-case economic outcome for the UK – further fueled market anxieties.
Evidence suggests that the negative repercussions of this uncertainty on employment, productivity, and investment in UK businesses became increasingly apparent in the years immediately following the referendum (Bloom et al, 2019).
Investor Expectations
The pound’s devaluation began before Brexit actually materialized. Conversely, exchange rate movements were relatively muted when the UK formally left the EU and the transition period concluded at the end of 2020. This highlights the crucial role of investor expectations in triggering currency movements (Dornbusch, 1976); Engle and West, 2005).
Shifting investor expectations are rapidly incorporated into currency markets due to the immense trading volume and speed. Any new information impacting currency expectations is swiftly reflected in exchange rates. If market participants anticipate a negative future impact on investments in a particular currency, they will sell that currency, causing its value to decline.
The record-breaking pound devaluation after the referendum illustrates the rapid influence of evolving market expectations on currencies, as the Leave vote surprised many observers. Last-minute polls suggested a likely Remain victory, initially causing Sterling to appreciate in the days leading up to the referendum. The subsequent pound collapse immediately following the result underscores the negative expectations financial market participants held for Sterling investments once the outcome became clear.
The significant pound depreciations in 2017 and 2019, during periods of heightened political uncertainty, also reflect increasingly negative expectations for Sterling-denominated investments driven by the growing likelihood of a ‘hard’ Brexit. Conversely, improved prospects for an orderly Brexit and a trade agreement preceded increases in the pound’s value.
Recent research has established specific links between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). Findings suggest that market participants factor in the level of policy uncertainty when forming their expectations, directly impacting currency valuations.
Consequences of a Weaker Pound
A direct consequence of pound depreciation is that imported goods, services, and assets become more expensive for UK residents. This translates into higher inflation rates and an increased cost of living.
However, a weaker currency can also offer advantages by making exports more competitive. Reduced costs of domestic goods and services for international buyers can potentially benefit a country’s trade deficit and overall economic growth.
Research examining the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions adds complexity, making the long-term economic outcome for the UK even more uncertain. Further research is essential to fully understand the long-term consequences of the Brexit-related pound depreciation.
Further Reading and Expert Insights
For deeper exploration into this topic, consider exploring resources from:
- 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)
This article was authored by Christopher Coyle.
Image depicting a mix of Pound Sterling and Euro coins, visually representing the currency exchange topic.
