At the beginning of 2021, the British pound was about 15% weaker against the euro compared to its position before the 2016 Brexit referendum. This represents a significant shift in the pound to euro exchange rate. Furthermore, Sterling’s value was down 20% from when the EU Referendum Act was enacted in December 2015. This article delves into the factors driving these changes in the pound euro rate and what they mean for the UK economy.
Over the past five years, Brexit has emerged as a dominant factor influencing the volatility of exchange rates, particularly the value of the pound against major currencies like the euro. The immediate aftermath of the referendum vote vividly illustrated this impact, with Sterling experiencing its most dramatic single-day drop in three decades. Further substantial and sustained declines occurred in 2017 and 2019, pushing the value of Sterling to new lows against both the euro and the dollar by August 2019, as depicted in Figure 1.
This depreciation primarily stemmed from growing expectations of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and ongoing political instability. These factors prompted financial institutions to sell off pound-denominated assets. As this selling pressure intensified, the value of the pound decreased relative to other currencies, impacting the pound and euro exchange rate significantly.
Figure 1: Pound/Euro Daily Exchange Rate Fluctuations (2015-2021)
Source: Bloomberg
The Mechanics of Exchange Rate Changes
An exchange rate represents the price of one currency in relation to another. These rates are governed by 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) based on buying and selling pressures. Increased demand for a currency leads to appreciation, while increased selling pressure causes depreciation.
The decline in Sterling’s value since the Brexit referendum signifies a reduced demand to hold pounds compared to other currencies. Understanding the underlying reasons for these Brexit-related exchange rate movements requires examining the factors that influence currency demand, specifically in the context of the pound to euro conversion rate.
Key Players in Exchange Rate Dynamics
Organizations engaged in international trade of goods and services are significant participants in currency markets. This includes multinational corporations involved in cross-border sales and individual travelers exchanging currency for personal expenses. For instance, when a UK entity purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars and affecting the pound to dollar exchange rate. Significant shifts in international trade flows can therefore impact currency demand and valuation.
However, the rapid and substantial depreciation of Sterling post-2016 predates any actual alterations in the UK-EU trading relationship. Moreover, trade in goods and services is not the primary driver of overall foreign exchange transactions and typically does not exhibit sharp short-term fluctuations (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade are not the main cause of extreme exchange rate volatility and might not be the primary reason for the Brexit-related drop in Sterling’s value against the euro, impacting the pound to euro exchange rate more broadly.
A critical factor behind the sharp declines in the pound since 2016 is a significant decrease in the inclination of financial institutions to hold pound-denominated investments. Currency trading for investment purposes, or financial asset trading, constitutes the largest portion of currency transactions and is typically the most significant driver of exchange rate changes, especially in the short term. This is particularly relevant when analyzing the history of the pound to euro exchange rate post-Brexit.
This type of investment-driven currency movement is often referred to as ‘hot money’ – highly mobile capital that can swiftly shift between investments or currencies on a large scale, rapidly influencing exchange rates. Consequently, major players in currency markets are financial institutions like banks, securities firms, and institutional investors. Their decisions have a profound impact on the GBP to EUR exchange rate.
In 2019, financial institutions (excluding foreign exchange dealers) accounted for 57.8% of foreign exchange turnover in the UK. Direct currency exchange volume from non-financial customers constituted only 4.9% (BIS, 2019). This highlights the dominant role of financial institutions in shaping exchange rates, including the euro to pound rate.
Furthermore, the UK’s persistent trade deficit, where imports exceed exports, increases reliance on ‘the kindness of strangers’ and makes the pound more susceptible to international capital flows. This vulnerability arises because the current account deficit has been increasingly financed by these capital inflows, making the pound to euro exchange rate forecast more sensitive to investor sentiment.
Brexit’s Negative Impact on Pound Appeal
The primary factors influencing financial institutions’ decisions in currency markets are those affecting the returns on investments in different currencies. The Brexit-related decline in Sterling’s value indicates that financial market participants anticipated poorer performance from pound-denominated investments following the Brexit vote compared to a scenario where the UK remained in the EU. This anticipation directly impacted the pound to euro exchange rate today and in the years following the referendum.
Numerous factors can influence returns in currency markets, making it challenging to isolate individual effects. However, key factors typically include changes in relative interest rates, shifts in perceived risk, and alterations in overall investor expectations, all of which played a role in the pound to euro exchange rate Brexit scenario.
Interest Rates
Changes in interest rates, or factors affecting them, are considered primary drivers of exchange rates. Domestic interest rates influence 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 (assuming other factors remain constant) will lead to decreased demand for those assets relative to similar assets in other currencies, causing a currency’s value to fall. This principle is fundamental to understanding fluctuations in the pound to euro exchange rate history.
For instance, 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 was announced weeks after the Brexit vote. Therefore, the significant drop in the pound’s value in June 2016, or in subsequent years, cannot be solely attributed to financial market reactions to this specific interest rate adjustment. While interest rates are a factor, they are not the sole explanation for the pound to euro exchange rate Brexit impact.
Uncertainty and Political Instability
Changes in perceived risk also affect expected returns and influence investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors like future company performance, economic prospects, interest rates, and political stability can make holding assets in a specific currency riskier. This uncertainty discourages or delays investment inflows (Pindyck, 1991). Brexit significantly amplified these risks for pound-denominated assets, directly impacting the pound to euro exchange rate.
The high likelihood of increased trade frictions between the UK and the EU post-Brexit intensified these risks. 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, prolonging and deepening uncertainty about post-Brexit trading relationships and the likely economic outcomes. The most substantial and sustained falls in the pound since 2016 were closely linked to heightened uncertainty and associated political turmoil, heavily influencing the pound to euro exchange rate.
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 fell to a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister and did not rule out a ‘no-deal’ Brexit – widely considered the worst-case economic scenario for the UK. Political events and Brexit uncertainty have been consistently correlated with fluctuations in the pound to euro exchange rate chart.
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 (Bloom et al, 2019).
Expectations
The depreciation of Sterling occurred before Brexit actually took place. Conversely, exchange rate movements were relatively minor when the UK officially left the EU and the transition period ended in late 2020. This is because investor expectations are a crucial trigger explaining the timing of currency movements (Dornbusch, 1976; Engle and West, 2005). Market expectations play a significant role in shaping the pound to euro exchange rate.
Changes in investor expectations are rapidly incorporated into currency markets due to the high volume and speed of trading. Any new information affecting currency expectations is quickly reflected in exchange rates. If market participants anticipate a negative future impact on investments in a currency, they will sell that currency, causing its value to decline. This anticipatory behavior is a key driver of the live pound to euro exchange rate.
The record fall of the pound after the referendum illustrates the rapid impact of changing market expectations on currencies, as the Leave vote surprised many analysts. Last-minute polls suggested a Remain victory, initially causing Sterling to appreciate in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately after the result highlights the negative expectations financial market participants held regarding Sterling investments once the outcome was clear. The surprise Brexit vote significantly impacted the pound to euro exchange rate converter.
The substantial pound declines in 2017 and 2019 occurred during periods of increased political uncertainty. These declines also reflect growing negative expectations for Sterling-denominated investments driven by the increasing likelihood of a ‘hard’ Brexit. Conversely, improved hopes for an orderly Brexit and a trade agreement preceded increases in the pound’s value. Market sentiment and Brexit news directly influence the pound to euro exchange rate trend.
Recent research has demonstrated 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 like the pound to euro exchange rate.
Consequences of Pound Depreciation
A direct consequence of Sterling’s depreciation is that foreign goods, services, and assets become more expensive for UK residents. This leads to increased inflation and a higher cost of living. For UK consumers, the weaker pound to euro exchange rate translates to higher prices for goods imported from the Eurozone.
However, a weaker currency can also be beneficial by making exports more competitive. Reduced costs of domestic goods and services for residents of other countries can potentially improve a country’s trade deficit and boost overall economic growth. A weaker pound to euro exchange rate could, in theory, make UK exports more attractive to Eurozone buyers.
Research on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions complicates the outlook for the UK economy. Understanding the long-term consequences of the Brexit-related fall in Sterling, and its impact on the pound to euro exchange rate, requires further investigation.
Further Reading
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)
