At the beginning of 2021, the British pound was significantly weaker against the euro compared to its position before the 2016 Brexit referendum. Specifically, the pound was approximately 15% weaker than it was in June 2016, just before the vote, and 20% weaker than in December 2015, when the EU Referendum Act was enacted.
Brexit has emerged as a dominant factor in the last five years, driving volatility and impacting the value of the pound sterling against major currencies, especially the euro. The immediate aftermath of the referendum vote vividly demonstrated this impact, with sterling experiencing its most significant single-day drop in three decades. Further substantial and sustained declines occurred in 2017 and 2019, pushing the pound to new lows against both the euro and the US dollar by August 2019, as illustrated in Figure 1.
This depreciation was largely attributed to growing expectations of increased trade barriers between the UK and the EU, its largest trading partner. This, coupled with heightened uncertainty and persistent political instability, prompted financial institutions to sell off pound-denominated assets. As the selling pressure intensified, the value of the pound naturally decreased relative to other currencies, most notably the euro.
Figure 1: Pound/Euro daily exchange rate 2015-2021
Source: Bloomberg
Decoding Exchange Rate Dynamics
An exchange rate is essentially the price of one currency expressed in terms of another. Like any price, it is governed by the fundamental principles of supply and demand. In a currency pair, when demand for one currency increases while supply of the other rises, the former will appreciate (increase in value), and the latter will depreciate (decrease in value).
In the context of the pound’s decline since the Brexit referendum, it indicates a decrease in the demand to hold pounds relative to other currencies, particularly the euro. To fully grasp the underlying causes of these Brexit-related exchange rate movements, we need to delve into the factors that influence the demand for a currency.
The Movers and Shakers of Exchange Rates
Organizations engaged in international trade of goods and services are integral participants in currency markets. This includes businesses involved in cross-border trade and individual travelers exchanging currencies for personal use. For instance, when a UK entity or individual purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars and influencing the GBP to USD exchange rate. Significant shifts in international trade flows can thus alter the demand for and value of a currency.
However, the sharp and rapid depreciation of the pound since 2016 preceded any actual changes in the trade relationship between the UK and the EU. Furthermore, the volume of trade in goods and services is not the primary driver of overall foreign exchange transactions and typically does not fluctuate drastically in the short term (Bank for International Settlements, BIS, 2019). This suggests that changes in goods and services trade may not be the primary factor behind the extreme exchange rate fluctuations observed and might not be the main reason for the Brexit-related pound depreciation.
A crucial factor behind the significant pound depreciation since 2016 is a notable decrease in the preference of financial institutions to hold investments denominated in pounds. Trading currencies for investment purposes, or trading in financial assets, constitutes the largest proportion of currency transactions and is generally the most significant driver of exchange rate changes, particularly in the short run.
This is often referred to as ‘hot money’ – highly mobile capital that can swiftly move between investments or currencies on a large scale, causing rapid exchange rate shifts. Consequently, the most influential participants 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 this, the UK’s persistent trade deficit, where imports consistently exceed exports, increases its reliance on ‘the kindness of strangers’ and makes the pound more vulnerable to international capital flows. This vulnerability arises because the current account deficit has been increasingly financed by these capital inflows.
Brexit’s Impact on Pound Sterling’s Appeal
The primary factors that financial institutions consider in currency markets are those that impact the returns on investments in different currencies. Therefore, the Brexit-related depreciation of the pound 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, and isolating the impact of each is challenging. However, some of the most significant factors typically include changes in relative interest rates, shifts in risk perception, and alterations in overall investor expectations.
Interest Rates
Changes in interest rates, or factors influencing them, are widely recognized as primary drivers of exchange rates. This is because domestic interest rates can affect the relative attractiveness of assets in different countries. A decrease in a country’s interest rates means that assets linked to that rate will yield a lower return. An unexpected interest rate cut (assuming other factors remain constant) will lead to reduced demand for those assets compared to similar assets in other currencies. Consequently, the value of the currency in question will decline.
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. It’s important to note, however, that this policy change was announced weeks after the Brexit vote. Therefore, the significant pound depreciation in June 2016, or in subsequent years, cannot be solely attributed to the financial market reaction to this specific interest rate change.
Uncertainty and Political Instability
Changes in risk perception can also impact expected returns and influence investor decisions regarding which assets, including currencies, to hold. Increased uncertainty surrounding factors like future company performance, economic prospects, interest rates, and political stability can make holding assets in a specific currency riskier, leading to reduced or delayed investment inflows (Pindyck, 1991).
The increased likelihood of greater trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Research conducted before the referendum predicted substantial declines in foreign investment in the UK as a consequence of Brexit-related trade costs (Dhingra et al, 2016).
These risks were further compounded by significant and persistent political instability in the UK, which 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 depreciations of sterling against the euro occurred in 2017. This followed 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 within days of Boris Johnson becoming Prime Minister and his refusal to rule out a ‘no-deal’ Brexit – widely considered the worst-case 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 (Bloom et al, 2019).
Expectations
The pound’s depreciation largely occurred before Brexit actually took place. Conversely, exchange rate movements were relatively minor when the UK formally left the EU and the transition period concluded at the end of 2020. This is because investor expectations are a crucial catalyst in explaining the timing of currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly incorporated into currency markets due to the immense volume and speed of trading. Any new information that influences expectations about a currency will swiftly be 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 fall.
The record-breaking pound depreciation after the referendum illustrates the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many observers. Last-minute polls suggested a likely Remain victory, which initially led to pound appreciation in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately after the result underscores the negative expectations that financial market participants held for pound investments once the outcome became clear.
The significant pound depreciations in 2017 and 2019 occurred during periods of heightened political uncertainty. These declines also reflect increasingly negative expectations for pound-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, improved hopes for an orderly Brexit and a trade agreement preceded increases in the pound’s value.
Recent research has demonstrated specific connections 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.
The Ripple Effects 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 inflation and a higher cost of living.
However, a weaker currency can also offer benefits. It can enhance export competitiveness by reducing the cost of domestic goods and services for buyers in other countries. This can potentially positively impact the country’s trade deficit and overall economic growth.
Research on the net effect of currency depreciation is, at best, inconclusive. Furthermore, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions makes the long-term economic outcome for the UK even more uncertain. Further research is needed to fully understand the long-term consequences of the Brexit-related pound depreciation on the pound to euro exchange rate and the broader UK economy.
Further Resources
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)
