The relationship between the UK pound sterling and the euro has undergone significant shifts, particularly since the UK’s vote to leave the European Union. At the beginning of 2021, the pound was approximately 15% weaker against the euro compared to its position before the June 2016 Brexit referendum. This devaluation is even more pronounced when considering the period before the EU Referendum Act in December 2015, showing a 20% decrease in sterling’s value.
Brexit has emerged as a central factor influencing the volatility of exchange rates and the pound’s valuation against major global currencies over the past half-decade. The immediate aftermath of the referendum vote vividly illustrated this impact, with sterling experiencing its most dramatic single-day fall 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 depicted in Figure 1.
This depreciation was largely driven by growing expectations of increased trade barriers between the UK and its largest trade partner, coupled with heightened uncertainty and ongoing political instability. These factors led financial institutions to reduce their holdings of sterling, triggering a sell-off of pound-denominated assets and consequently driving down the pound’s value relative to other currencies.
The Mechanics of Exchange Rate Fluctuations
An exchange rate represents the price of one currency in terms of another. Like any price in a market economy, it is governed by the principles of supply and demand. In a currency pair, when demand for one currency increases relative to the other, its value appreciates, and the other currency depreciates.
The post-referendum decline in sterling’s value indicates a decreased demand for holding pounds compared to other currencies. To understand the fundamental drivers behind these Brexit-related exchange rate movements, it’s essential to examine the factors that influence the demand for a currency.
Key Players in Currency Exchange Markets
Participants in international trade of goods and services are significant actors in currency markets. This includes businesses engaged in cross-border sales and individual travelers exchanging currency for personal spending. For instance, when a UK entity imports goods from the Eurozone, it must convert pounds into euros, thereby increasing the demand for euros. Significant shifts in international trade flows can therefore impact currency demand and valuation.
However, the rapid and substantial drops in sterling’s value since 2016 occurred prior to any actual changes in the trade relationship between the UK and the EU. Moreover, the volume of foreign exchange transactions driven by trade in goods and services is not the primary component of overall currency market activity and tends to exhibit less short-term volatility (Bank for International Settlements, BIS, 2019). This suggests that factors beyond trade in goods and services were the main drivers of the extreme exchange rate fluctuations and the Brexit-related depreciation of sterling.
A critical factor behind the sharp falls in the pound’s value 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 share of currency transactions and is typically the most influential driver of exchange rate changes, particularly in the short term.
This type of capital flow is often referred to as ‘hot money’ – highly mobile capital that can move rapidly between investments or currencies, exerting a swift and substantial impact on exchange rates. 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).
Furthermore, the UK’s persistent trade deficit, where imports exceed exports, contributes to a reliance on international capital inflows to finance this deficit. This reliance, sometimes referred to as being at the ‘kindness of strangers’, makes the pound more susceptible to international capital movements. The current account deficit has become increasingly funded by these capital inflows, amplifying the pound’s vulnerability.
Brexit’s Impact on Sterling’s Appeal
Financial institutions’ decisions in currency markets are primarily driven by factors that influence the expected returns on investments in different currencies. Therefore, the Brexit-related depreciation of sterling indicates that financial market participants anticipated that investments in pound-denominated assets would perform less favorably post-Brexit than they would have otherwise.
While numerous factors can influence returns in currency markets, and isolating the individual effects is complex, some of the most crucial factors include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations.
Interest Rates
Changes in interest rates, or factors influencing them, are considered primary drivers of exchange rates. Domestic interest rates affect 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 decrease in interest rates, all else being equal, leads to decreased demand for those assets compared to assets in currencies offering higher returns. This, in turn, causes 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 occurred weeks after the Brexit vote. Therefore, the significant drop in the pound’s value in June 2016, and in subsequent years, cannot be solely attributed to the market’s reaction to this specific interest rate change.
Uncertainty and Political Instability
Changes in risk perceptions also impact expected returns and influence investor decisions regarding asset and currency holdings. Increased uncertainty surrounding factors like future business performance, economic prospects, interest rate paths, and political stability can elevate the perceived risk of holding assets in a specific currency. This heightened risk can reduce or delay investment inflows.
The increased likelihood of trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Research conducted before the referendum predicted significant declines in foreign investment in the UK due to Brexit-related trade costs.
These risks were further compounded by substantial and persistent political instability in the UK, which prolonged and deepened uncertainty regarding post-Brexit trade relationships and the anticipated economic outcomes. The most significant and sustained falls in the pound since 2016 were closely linked to 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 consequences of this uncertainty on employment, productivity, and investment in UK businesses became increasingly apparent in the years immediately following the referendum.
Expectations
The depreciation of sterling largely preceded the actual implementation of Brexit. Conversely, exchange rate movements were relatively muted when the UK formally left the EU and the transition period concluded at the end of 2020. This is because investor expectations play a crucial role in triggering currency movements.
Changes in investor expectations are rapidly incorporated into currency markets due to the immense volume and speed of trading. Any new information that alters expectations about a currency’s future prospects is quickly reflected in exchange rates. If market participants anticipate negative future impacts on investments in a particular currency, they will sell that currency, causing its value to decline.
The record fall of the pound after the referendum illustrates the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many observers. Pre-referendum polls suggested a likely Remain victory, initially causing sterling 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 financial market participants held for sterling 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 reflected increasingly pessimistic expectations for sterling-denominated investments due to the rising probability of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade agreement led to increases in the pound’s value.
Recent research has highlighted specific connections between economic policy uncertainty and exchange rate expectations. These findings suggest that market participants factor in the level of policy uncertainty when forming their expectations, which in turn influences exchange rate dynamics.
Consequences of Sterling’s Depreciation
One immediate consequence of a weaker sterling 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. It can enhance export competitiveness by reducing the cost of domestic goods and services for buyers in other countries. This can potentially improve a country’s trade balance and contribute to overall economic growth.
Research on the net effects of currency depreciation is 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 ambiguous. Further research is needed to fully understand the longer-term consequences of the Brexit-related fall in sterling.
Further Resources
For deeper insights into this topic, consider exploring resources from institutions specializing in economic analysis and currency markets.
Experts in the Field
- 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)
By: Christopher Coyle
Photo by PublicDomainPictures from Pixabay
