At the beginning of 2021, the British pound (GBP) was significantly weaker against the euro (EUR) 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, just before the vote on the UK’s membership in the European Union (EU). Furthermore, sterling was down 20% compared to December 2015, when the EU Referendum Act received Royal Assent.
Brexit has been a dominant factor in the fluctuations of the GBP/EUR exchange rate over the past five years. The immediate aftermath of the referendum saw the pound experience its most significant single-day drop in 30 years. Two more 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 largely stemmed from expectations of increased trade barriers between the UK and the EU, its largest trading partner. Coupled with heightened uncertainty and ongoing political instability, these factors led financial institutions to sell off pound-denominated assets. This widespread selling pressure further drove down the value of the pound relative to other currencies, including the euro.
Figure 1: Pound/Euro Daily Exchange Rate 2015-2021
Source: Bloomberg
The Mechanics of Exchange Rate Fluctuations
An exchange rate represents the price of one currency in relation to another. Like any price in a market economy, it is governed by supply and demand. In the context of currency exchange, when demand for one currency increases relative to another, its value appreciates, and the value of the other currency depreciates.
The post-referendum decline in the pound’s value signifies a decrease in the demand for holding pounds compared to other currencies. Therefore, understanding the fundamental reasons behind Brexit’s impact on the GBP/EUR exchange rate requires examining the factors that influence currency demand.
Key Players in Exchange Rate Dynamics
Participants in the international trade of goods and services play a crucial role in currency markets. This includes businesses engaged in cross-border trade and individual travelers exchanging currency for personal expenses. For instance, when a UK business imports goods from the Eurozone, they need to convert pounds into euros, thereby increasing the demand for euros and potentially affecting the GBP/EUR exchange rate. Significant shifts in international trade flows can thus alter currency demand and valuation.
However, the sharp and rapid depreciation of the pound following 2016 occurred before any actual changes in the UK-EU trading relationship were implemented. Moreover, trade in goods and services is not the primary driver of overall foreign exchange transactions and tends to be less volatile in the short term (Bank for International Settlements, BIS, 2019). This suggests that factors beyond trade in goods and services were the main catalysts for the Brexit-related decline in the pound’s value against the euro.
A critical factor contributing to the pound’s depreciation since 2016 is a significant reduction 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 portion of currency transactions and is typically the most significant driver of exchange rate movements, particularly in the short term.
This investment-driven currency movement is often referred to as ‘hot money’ – capital that is highly mobile and can swiftly move between investments or currencies on a large scale, rapidly impacting exchange rates. Consequently, the most influential players in currency markets are financial institutions such as banks, investment 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).
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, contributes to a current account deficit. This deficit increases the UK’s reliance on international capital inflows and makes the pound more susceptible to the fluctuations of global capital flows, often described as relying on the ‘kindness of strangers’. The current account deficit has been increasingly financed by these capital inflows, making the pound’s value more sensitive to investor sentiment.
Brexit’s Impact on the Pound’s Appeal
Financial institutions’ decisions in currency markets are primarily driven by factors influencing the expected return on investments in different currencies. The post-Brexit depreciation of the pound indicates that financial market participants perceived investments in pound-denominated assets as less attractive following the referendum outcome.
Several factors can influence returns in currency markets, and isolating the impact of each is complex. However, some of the most significant factors typically include changes in relative interest rates, shifts in risk perception, and evolving investor expectations.
Interest Rates
Changes in interest rates, or factors affecting interest rates, are considered primary 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 reduces the returns on assets linked to that rate. An unexpected interest rate cut, assuming other factors remain constant, typically leads to a decrease in demand for those assets relative to assets in other currencies. This, in turn, causes a depreciation of the currency in question.
For instance, in response to the Brexit vote, the Bank of England lowered interest rates in August 2016 from 0.5% to 0.25% and expanded its program of ‘quantitative easing’ (QE). However, this policy change was announced weeks after the Brexit referendum. Therefore, the initial sharp fall in the pound’s value in June 2016 and subsequent declines cannot be solely attributed to the immediate market reaction to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in risk perception can also significantly impact expected returns and influence investors’ decisions about which assets, including currencies, to hold. Increased uncertainty surrounding factors such as future company performance, economic prospects, interest rate trajectories, and political stability can make holding assets in a particular currency riskier, leading to reduced or delayed investment flows (Pindyck, 1991).
The increased likelihood of trade frictions 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 (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 falls in the pound since 2016 were closely correlated with periods of heightened 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 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 impacts 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 largely occurred before Brexit formally took place. 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 crucial role of investor expectations in driving currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly incorporated into currency markets due to the high volume and speed of trading. Any new information that affects expectations regarding a currency’s future performance is quickly reflected in exchange rates. If market participants anticipate negative future implications for investments in a particular currency, they will sell that currency, causing its value to fall.
The record plunge in the pound after the referendum illustrates the swift impact of shifting market expectations on currencies, as the Leave vote surprised many analysts. Pre-referendum polls suggested a likely Remain victory, initially causing the pound to appreciate in the days leading up to the vote. 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 drops in the pound in 2017 and 2019 coincided with periods of increased political uncertainty. These declines also reflect increasingly pessimistic expectations for pound-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, improved prospects for an orderly Brexit and a trade agreement preceded increases in the pound’s value.
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 exchange rate expectations.
Consequences of a Weaker Pound
A direct consequence of a weaker pound is that goods, services, and assets from countries using the euro become more expensive for UK consumers and businesses. This leads to increased inflation and a higher cost of living.
However, a weaker currency can also offer advantages. It can make exports more competitive by reducing the cost of UK goods and services for buyers in other countries, potentially improving the UK’s trade deficit and boosting overall economic growth.
Research on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the extent and implications of post-Brexit trade frictions complicates predictions for the UK economy. Understanding the long-term consequences of the Brexit-related fall in the pound against the euro requires further in-depth analysis.
Further Reading and Expert Insights
For deeper exploration of this topic, consider exploring resources from the experts listed below:
Experts in Exchange Rate Economics
- 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)
