Since the beginning of 2021, the UK pound has remained significantly weaker against the euro compared to its position before the 2016 Brexit referendum. Specifically, the pound was approximately 15% lower against the euro than it was in June 2016, prior to the vote on the UK’s membership in the European Union (EU). This devaluation is even more pronounced when compared to December 2015, when the EU Referendum Act was enacted, showing a 20% decrease in sterling’s value.
Brexit has undeniably been a central factor in the volatility of exchange rates over the past half-decade, and particularly in the fluctuating value of the pound relative to major currencies like the euro. The immediate aftermath of the referendum showcased this impact dramatically. Sterling experienced its most significant single-day drop in 30 years following the referendum result. Further substantial and sustained declines occurred in 2017 and 2019, driving the pound to new lows against both the euro and the US dollar by August 2019, as illustrated in Figure 1.
This depreciation primarily stemmed from growing expectations of increased trade barriers between the UK and the EU, its largest trading partner. Compounded by heightened uncertainty and ongoing political instability, these factors prompted financial institutions to sell off pound-denominated assets. As this trend gained momentum, the value of the pound diminished relative to other currencies, including the euro.
Decoding Exchange Rate Shifts
An exchange rate represents the price of one currency in relation to another. These rates 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 will appreciate in value, and the latter will depreciate.
Fundamentally, the weakening of the pound since the referendum reflects a decrease in the demand to hold pounds compared to other currencies. To truly grasp the underlying causes of these Brexit-related exchange rate movements, we must explore the factors that influence the demand for a particular currency.
The Key Players in Exchange Rate Dynamics
Organizations engaged in international trade of goods and services are significant and familiar participants in currency markets. This includes businesses involved in cross-border sales and individual travelers exchanging currency for personal use. For instance, when a UK entity purchases goods from the United States, they need to convert pounds into dollars, thus increasing the demand for dollars. Substantial shifts in international trade volumes can therefore impact currency demand and valuation.
However, the rapid and significant declines in the pound’s value since 2016 predated any actual changes in the trading relationship between the UK and the EU. Furthermore, trade in goods and services isn’t the primary driver of overall foreign exchange transactions, nor does it typically change dramatically in the short term (according to the Bank for International Settlements, BIS, 2019). This suggests that alterations in goods and services trade are not the main cause of extreme exchange rate fluctuations, and likely weren’t the primary reason for the pound’s Brexit-related depreciation.
A critical factor behind the sharp falls in the pound since 2016 is the substantial decrease in financial institutions’ preference to hold investments in pounds. Currency trading for investment purposes, or financial asset trading, constitutes the majority of currency transactions and is typically the most significant driver of exchange rate changes, especially in the short run.
This type of capital movement is often referred to as ‘hot money’ – highly mobile funds that can be rapidly shifted between investments or currencies on a large scale, leading to swift exchange rate impacts. 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).
Moreover, the UK’s persistent trade deficit, where imports consistently exceed exports, increases its reliance on international capital inflows and makes the pound more susceptible to global capital movements. This vulnerability arises because the current account deficit has been increasingly financed by these very capital inflows.
Why Brexit Diminished the Pound’s Appeal
Financial institutions operating in currency markets primarily respond to factors that influence the potential returns on investments in different currencies. Therefore, the Brexit-related depreciation of the pound indicates that financial market participants anticipated poorer performance for pound-denominated investments post-Brexit.
Numerous factors can potentially affect returns in currency markets, making it complex to isolate individual effects. However, key factors typically include shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.
Interest Rates
Changes in interest rates, or factors impacting them, are considered major drivers of exchange rates. Domestic interest rates can influence the relative attractiveness of assets in different countries. A decrease in a country’s interest rates diminishes the returns on assets linked to that rate. 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, causing the currency’s value to fall.
For instance, 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. The significant pound devaluation 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
Changes in perceived risk also significantly impact expected returns and influence investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors like future business performance, economic forecasts, interest rates, and political stability can make holding assets in a particular currency riskier, leading to reduced or delayed investment inflows.
The heightened probability of increased trade friction 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.
These risks were further exacerbated by significant and persistent political instability in the UK, which prolonged and deepened uncertainty surrounding post-Brexit trade relationships and the likely economic outcomes. The most substantial and sustained pound depreciations since 2016 were closely linked to increased uncertainty and associated political turbulence.
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 plummeted to a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister and refused 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 for employment, productivity, and investment in UK businesses became increasingly apparent in the years immediately following the referendum.
Expectations
The pound’s devaluation largely occurred before Brexit actually materialized. Conversely, exchange rate movements were relatively minor when the UK officially left the EU and the transition period concluded at the end of 2020. This timing highlights the crucial role of investor expectations in triggering currency movements.
Changes in investor expectations are rapidly incorporated into currency markets due to the sheer volume and speed of trading. Any new information that affects expectations about a currency is swiftly reflected in exchange rates. If market participants anticipate negative future impacts on investments in a currency, they will sell it, causing its value to decline.
The record fall in the pound after the referendum illustrates the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many analysts. Last-minute polls suggested a likely Remain victory, initially causing the pound to appreciate 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 developed for sterling investments once the outcome was clear.
The significant pound declines in 2017 and 2019, during periods of heightened political uncertainty, also reflect increasingly negative expectations for pound-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade deal were preceded by increases in the pound’s value.
Recent research has established specific links between economic policy uncertainty and exchange rate expectations. Findings indicate that market participants consider the level of policy uncertainty when forming their expectations.
Consequences of Pound Sterling Depreciation
A direct consequence of a weaker pound is that imported 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 offer benefits by making exports more competitive. It reduces the cost of domestic goods and services for residents of other countries, potentially improving the country’s trade deficit and boosting overall economic growth.
Research on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions makes the long-term outcome for the UK even more uncertain. Further research is needed to fully understand the long-term consequences of the Brexit-related pound depreciation.
Further Resources
Experts on the Subject
- 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)
