The journey of the Sterling To Euro exchange rate has been significantly shaped by Brexit. Since the UK voted to leave the European Union in June 2016, the British pound has experienced considerable volatility against the euro. At the beginning of 2021, the pound was approximately 15% weaker against the euro compared to its position before the referendum. This represents a 20% decrease in value since December 2015, when the EU Referendum Act was enacted.
Brexit stands out as a primary driver influencing the fluctuations and value of the pound against major global currencies over the past half-decade. The immediate aftermath of the referendum vote vividly illustrated this impact. Sterling endured its most significant single-day drop in 30 years, signaling the market’s abrupt reassessment of the UK’s economic outlook. 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 devaluation largely stemmed from expectations of increased trade barriers between the UK and its largest trade partner, coupled with heightened uncertainty and ongoing political instability. These factors prompted financial institutions to sell off pound-denominated assets, driving down the value of the pound relative to other currencies as selling pressure intensified.
The Mechanics of Exchange Rate Fluctuations
An exchange rate reflects the price of one currency in relation to another. It’s 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 shifts in demand. Increased demand for a currency drives its value up, while increased supply pushes it down.
Essentially, the post-referendum decline in the sterling to euro exchange rate indicates a reduced demand for holding pounds compared to euros and other currencies. To fully grasp the Brexit-related exchange rate movements, it’s crucial to understand the factors that influence currency demand.
Key Players in Exchange Rate Dynamics
Participants in international trade, dealing in goods and services, are significant actors in currency markets. This includes businesses engaged in cross-border trade and individual travelers exchanging currency for personal expenses. For example, when a UK entity purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars. Significant shifts in international trade volumes can therefore influence currency demand and valuation.
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. Moreover, trade in goods and services is not the primary source of foreign exchange transactions and typically doesn’t fluctuate dramatically in the short term (Bank for International Settlements, BIS, 2019). This suggests that trade in goods and services may not be the main catalyst for extreme exchange rate volatility, and perhaps not the primary cause of the Brexit-related fall in the value of sterling against the euro.
A critical factor behind the significant drop in the sterling to euro rate since 2016 is the substantial decrease in financial institutions’ inclination to hold pound-denominated investments. Trading currencies for investment purposes, or trading in financial assets, constitutes the largest segment of currency transactions and is typically the most significant driver of exchange rate fluctuations, 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 at scale, rapidly impacting exchange rates. Consequently, the most influential participants in currency markets are financial institutions, including 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. Direct transactions from non-financial customers represented only 4.9% of the currency exchange volume (BIS, 2019).
Furthermore, the UK’s persistent trade deficit, where imports exceed exports, increases reliance on external financing and makes the pound more susceptible to international capital flows. This is because the current account deficit has become increasingly reliant on these capital inflows to be funded.
Brexit’s Impact on Pound Sterling’s Appeal
Financial institutions in currency markets primarily respond to factors affecting investment returns in different currencies. Therefore, the decline in the sterling to euro exchange rate post-Brexit indicates that financial market participants anticipated poorer performance from pound-denominated investments following the Brexit vote.
Numerous factors can influence returns in currency markets, making it challenging to isolate individual effects. However, key drivers typically include changes in relative interest rates, risk perceptions, and overall investor expectations.
Interest Rates
Interest rate changes, or factors influencing them, are considered major drivers of exchange rates, including the sterling to euro rate. Domestic interest rates impact the relative attractiveness of assets across different countries. Lower interest rates in a country reduce the returns on assets linked to that rate. An unexpected interest rate decrease (all else being equal) will lead to decreased demand for those assets relative to assets in other currencies, causing a depreciation of the currency in question.
For instance, the Bank of England lowered interest rates in August 2016 from 0.5% to 0.25% and expanded its ‘quantitative easing’ (QE) program in response to the Leave vote. However, this policy change occurred weeks after the Brexit vote. Therefore, the immediate drop in the sterling to euro rate in June 2016, or subsequent years, cannot be solely attributed to the market’s reaction to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in perceived risk also affect expected returns and influence investment decisions, including currency holdings. Increased uncertainty surrounding factors like future business performance, economic prospects, interest rates, and political stability can elevate the risk of holding assets in a particular currency. This can lead to reduced or delayed investment inflows (Pindyck, 1991).
The heightened probability of increased trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets, negatively impacting the sterling to euro exchange rate. Pre-referendum research predicted significant declines in foreign investment in the UK due to Brexit-related trade costs (Dhingra et al, 2016).
These risks were exacerbated by substantial and persistent political instability in the UK, prolonging and deepening uncertainty about post-Brexit trade relationships and the anticipated economic outcomes. The most significant and sustained declines in the pound since 2016, impacting the sterling to euro rate, were closely linked to increased uncertainty and associated political turmoil.
A notable drop 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. His refusal to rule out a ‘no-deal’ Brexit – widely considered the worst-case economic scenario for the UK – further fueled negative sentiment impacting the sterling to euro exchange rate.
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 the pound, affecting the sterling to euro rate, largely predated the actual Brexit. Conversely, exchange rate fluctuations were relatively minor when the UK officially left the EU and the transition period concluded at the end of 2020. This is because investor expectations are a crucial trigger in currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly incorporated into currency markets due to the sheer volume and speed of trading. Any new information affecting currency expectations is quickly reflected in exchange rates, influencing the sterling to euro dynamic. If market participants anticipate negative future impacts on investments in a currency, they will sell that currency, causing its value to decline.
The record drop in the pound after the referendum illustrates the swift 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 following the result underscored the negative expectations that financial market participants held for sterling investments once the outcome was clear, significantly impacting the sterling to euro rate.
The substantial falls in the pound in 2017 and 2019, further shifting the sterling to euro rate, occurred during periods of heightened political uncertainty. These declines reflect increasingly negative expectations for sterling-denominated investments, fueled by the growing likelihood of a ‘hard’ Brexit. Conversely, increased optimism regarding an orderly Brexit and a trade deal led to increases in the pound’s value against the euro and other currencies.
Recent research has established specific links between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). Findings indicate that market participants factor in the level of policy uncertainty when forming their expectations, directly influencing exchange rates like the sterling to euro rate.
Consequences of a Weaker Pound
A direct consequence of a weaker pound, impacting the sterling to euro exchange rate, is that foreign goods, services, and assets become more expensive for UK residents. This leads to increased inflation and a higher cost of living.
However, a weaker currency can also be advantageous. It can enhance export competitiveness by reducing the cost of domestic goods and services for international buyers. This potentially benefits a country’s trade deficit and overall economic growth.
Research on the net effects of currency depreciation, including its impact on the sterling to euro balance, is inconclusive. Furthermore, ongoing uncertainty surrounding the magnitude and implications of post-Brexit trade frictions complicates predictions for the UK economy. Further research is needed to fully understand the long-term consequences of the Brexit-related depreciation of sterling and its persistent effect on the sterling to euro exchange rate.
Further Reading
Experts on Sterling and Euro Exchange Rates:
- 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)
