At the dawn of 2021, the British pound (GBP), also known as pound sterling, found itself significantly weakened against the euro (EUR). Specifically, it was approximately 15% lower than its value on the eve of the UK’s pivotal referendum on European Union (EU) membership in June 2016. This depreciation was even more stark when compared to December 2015, when the EU Referendum Act received Royal Assent, revealing a 20% decrease in sterling’s strength.
The past half-decade has seen Brexit emerge as a dominant force shaping exchange rate volatility and the pound sterling’s value against major global currencies, most notably the euro. The immediate aftermath of the referendum vote vividly illustrated this impact. Sterling endured its most dramatic single-day plunge in three decades, a clear indication of market upheaval. Further substantial and sustained declines followed in 2017 and 2019, culminating in the pound hitting new lows against both the euro and the US dollar by August 2019, as illustrated in Figure 1.
This devaluation largely stemmed from growing expectations of increased trade barriers between the UK and the EU, its largest trading partner. Compounded by heightened uncertainty and persistent political instability, these factors spurred financial institutions to divest from the pound. As organizations increasingly sold assets denominated in sterling, the currency’s value was inevitably driven down relative to others, such as the euro.
Understanding Exchange Rate Dynamics
To grasp the fluctuations in the pound sterling against the euro, it’s crucial to understand the fundamentals of exchange rates. An exchange rate represents the price of one currency in relation to another. These rates are not static; they fluctuate based on the principles of supply and demand. In any currency pair, when demand for one currency increases and supply of the other rises, the former appreciates (increases in value) while the latter depreciates (decreases in value).
The post-referendum decline in the pound sterling’s value signifies a reduced demand for holding pounds compared to other currencies, particularly the euro. Therefore, to comprehensively understand the Brexit-induced exchange rate shifts, we must explore the factors that underpin currency demand.
The Key Players in Exchange Rate Fluctuations
Participants in international trade, dealing in goods and services, are significant actors in currency markets. This includes multinational corporations engaged in cross-border commerce and individual travelers exchanging currency for personal spending. For instance, when a UK entity or individual purchases goods from the United States, they must convert pounds into dollars, thereby boosting the demand for dollars. Significant shifts in international trade patterns can thus influence currency demand and valuation.
However, the rapid and pronounced depreciations of the pound sterling following 2016 occurred before any tangible changes in the UK-EU trading relationship. Moreover, while important, trade in goods and services isn’t the primary driver of overall foreign exchange transactions and typically doesn’t exhibit sharp short-term volatility (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade are not the primary catalyst for extreme exchange rate fluctuations and may not be the central explanation for the Brexit-related fall in the pound’s value against the euro.
A more critical factor in the sharp declines of the pound sterling since 2016 is a substantial decrease in the inclination of financial institutions to hold investments denominated in pounds. The trading of currencies for investment purposes, or financial asset trading, constitutes the largest proportion of currency transactions and is generally the most potent driver of exchange rate movements, especially 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, causing rapid exchange rate adjustments. Consequently, the most influential players in currency markets are financial institutions, including 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 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 the ebb and flow of international capital, as it has become increasingly reliant on these capital inflows for funding.
Brexit’s Impact on the Pound’s Appeal
The diminished attractiveness of the pound sterling in currency markets, particularly against the euro, following Brexit can be attributed to factors influencing investment returns. Financial institutions primarily respond to elements that impact the profitability of investments across different currencies. The post-Brexit depreciation of sterling indicates that financial market participants anticipated that investments in pound-denominated assets would perform less favorably after the Brexit vote than they would have otherwise.
Numerous variables can influence returns in currency markets, making it challenging to isolate individual effects. However, some of the most prominent factors typically include shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.
Interest Rates and Currency Value
Changes in interest rates, or factors affecting them, are widely recognized as key drivers of exchange rates. Domestic interest rates can significantly impact 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 interest rate cut (assuming other factors remain constant) leads to decreased demand for those assets compared to similar assets in currencies offering higher returns, causing a depreciation of the currency in question.
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 adjustment was announced weeks after the Brexit referendum. 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 policy change.
Uncertainty and Political Instability as Risk Factors
Risk perceptions also play a critical role in expected returns and shape investor decisions regarding currency holdings. Heightened uncertainty surrounding factors such as future company performance, economic forecasts, interest rate trajectories, and political stability can make assets in a specific currency riskier, leading to reduced or delayed investment inflows.
The increased probability of trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Pre-referendum research projected substantial declines in foreign investment in the UK due to Brexit-related trade costs.
These risks were further exacerbated by significant and persistent political instability in the UK. This prolonged uncertainty surrounding post-Brexit trade arrangements and the likely economic consequences. The most substantial and sustained falls in the pound since 2016 coincided with periods of heightened uncertainty and associated political turmoil.
A notable example is the sharp fall in sterling’s value against the euro in 2017, following an early general election that resulted in a hung parliament. Similarly, in 2019, the pound plummeted to a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister and indicated a willingness to consider a ‘no-deal’ Brexit – widely considered the worst-case 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
Crucially, the depreciation of the pound sterling largely preceded the actual implementation of Brexit. In contrast, exchange rate movements were relatively muted when the UK officially left the EU and the transition period concluded at the end of 2020. This timing highlights the significant role of investor expectations in driving currency movements.
Changes in investor expectations are rapidly incorporated into currency markets due to the sheer volume and speed of trading. 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 fall.
The record-breaking fall of the pound sterling after the referendum exemplifies the rapid impact of shifting market expectations. The Leave vote surprised many analysts, as last-minute polls suggested a likely Remain victory, which had initially caused sterling to appreciate in the days leading up to the vote. The subsequent collapse in the pound’s value immediately after the result underscored the negative expectations financial market participants held for pound investments in the wake of the Leave outcome.
The significant drops in the pound in 2017 and 2019, during periods of heightened political uncertainty, also reflect increasingly pessimistic expectations for sterling-denominated investments due to the growing likelihood of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade deal led to appreciations 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 currency outlook.
Consequences of a Weaker Pound Sterling
One immediate consequence of a weaker pound sterling is that imported goods, services, and assets become more expensive for UK residents. This directly translates to increased 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 domestic goods and services for international buyers. This, in turn, could positively impact the country’s trade deficit and overall economic growth.
Research examining the net effect of currency depreciation presents mixed findings. Furthermore, ongoing uncertainty surrounding the magnitude and implications of post-Brexit trade frictions makes the long-term economic outcome for the UK even more ambiguous. A comprehensive understanding of the longer-term consequences of the Brexit-related fall in the pound sterling against the euro necessitates further in-depth research and analysis.
Expert Insights on Currency Dynamics
For further exploration of this topic, consider consulting the expertise of:
- 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)
