The relationship between the UK Pound Sterling (GBP) and the Euro (EUR) has been significantly shaped by Brexit. Since the 2016 referendum on the UK’s membership in the European Union (EU), the value of the pound against the euro has experienced considerable fluctuations. At the beginning of 2021, the pound was notably weaker against the euro, approximately 15% lower than its value on the eve of the Brexit referendum in June 2016, and 20% weaker than when the EU Referendum Act was enacted in December 2015.
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 vividly illustrated this impact, with Sterling enduring 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 depicted in Figure 1.
This devaluation largely stemmed from expectations of increased trade barriers between the UK and the EU, its largest trading partner. Compounded by heightened uncertainty and persistent political instability, these factors prompted financial institutions to divest from the pound. As the volume of sterling-denominated asset sales increased, the pound’s value depreciated relative to other currencies, impacting the Uk Gbp To Euro exchange rate significantly.
Source: Bloomberg
Decoding Exchange Rate Dynamics: Supply and Demand
An exchange rate represents the price of one currency in relation to another. Its fluctuations are governed by the fundamental principles of supply and demand. In any currency pair, when demand for one currency increases relative to the other, its value appreciates, while the counterpart currency depreciates.
The post-referendum decline in the pound’s value signifies a decrease in the demand to hold pounds compared to other currencies. Therefore, understanding the underlying reasons for Brexit-related exchange rate movements requires identifying the factors that influence the demand for a currency, and consequently, the UK GBP to Euro exchange rate.
Key Players in Exchange Rate Shifts
Organizations engaged in international trade of goods and services are crucial participants in currency markets. This includes businesses involved in cross-border transactions and individual travelers exchanging currency for personal use. For instance, when a UK entity imports goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars and affecting the GBP to USD exchange rate. Significant shifts in international trade volumes can therefore alter currency demand and values across the board.
However, the rapid and substantial depreciation of the pound since 2016 occurred before any tangible changes in the UK-EU trading relationship. Furthermore, the volume of trade in goods and services is not the primary driver of overall foreign exchange transactions and tends to be relatively stable in the short term (Bank for International Settlements, BIS, 2019). This suggests that changes in the trade of goods and services might not be the primary cause of the extreme exchange rate fluctuations and may not fully explain the Brexit-related fall in the UK GBP to Euro exchange rate.
A critical factor behind the sharp declines in the pound’s value since 2016 is the significant reduction in the preference of financial institutions to hold investments denominated in pounds. Currency trading for investment purposes, or trading in financial assets, constitutes the majority of currency transactions and is typically the most significant driver of exchange rate changes, especially in the short run.
This is often referred to as ‘hot money’ – capital that is highly mobile and can shift between investments or currencies rapidly and on a large scale, causing swift impacts on exchange rates, including the UK GBP to Euro exchange rate. 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 attributable to non-financial customers (BIS, 2019).
Moreover, the UK’s persistent trade deficit, where imports consistently exceed exports, increases reliance on ‘the kindness of strangers’ and makes the pound more susceptible to international capital flows. This vulnerability arises because the current account deficit has been increasingly financed by these capital inflows, further influencing the UK GBP to Euro exchange rate.
Brexit’s Impact on Pound Sterling’s Attractiveness
The primary factors that financial institutions consider in currency markets are those that influence the returns on investments in different currencies. Therefore, the depreciation of the pound linked to Brexit indicates that financial market participants anticipated that investments in pound-denominated assets would perform worse following the Brexit vote than they would have otherwise, directly impacting the UK GBP to Euro exchange rate.
Several factors can potentially affect returns in currency markets, and isolating the individual effects is complex. However, some of the most influential factors typically include changes in relative interest rates, shifts in risk perception, and changes in overall investor expectations.
Interest Rates
Changes in interest rates, or factors affecting them, are considered major drivers of exchange rates, including the UK GBP to Euro exchange rate. This is because domestic interest rates can influence the relative return on assets in different countries. A decrease in interest rates in a country reduces the return on assets linked to that rate. An unexpected interest rate cut (assuming other factors remain constant) will lead to decreased demand for those assets relative to similar assets in other currencies. 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, it’s important to note that this policy change was announced weeks after the Brexit vote. Therefore, the significant drop in the pound’s value 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 asset holdings, including currencies like the UK GBP to Euro. Increased uncertainty surrounding factors such as future company performance, economic outlook, interest rates, and political stability can make holding assets in a specific currency riskier. This risk increase can reduce or delay investment inflows (Pindyck, 1991).
The heightened likelihood of increased 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 due to Brexit-related trade costs (Dhingra et al, 2016).
These risks were further compounded by significant and persistent political instability in the UK, prolonging and deepening uncertainty regarding post-Brexit trading relationships and the likely economic outcomes. The most substantial and sustained declines in the pound since 2016 were closely linked to increased uncertainty and associated political turmoil, directly affecting the UK GBP to Euro exchange rate.
One of the most significant drops in sterling’s value against the euro occurred in 2017. This followed a snap 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 refused to rule out a ‘no-deal’ Brexit – widely considered the worst-case economic scenario for the UK, severely impacting the UK GBP 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 largely predated the actual Brexit implementation. Conversely, exchange rate movements were relatively minor when the UK officially left the EU and the transition period ended at the close of 2020. This timing is explained by the crucial role of investor expectations in triggering 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 about a currency is quickly reflected in exchange rates, including the UK GBP to Euro exchange rate. If market participants anticipate a negative future impact on investments in a currency, they will sell that currency, causing its value to decline.
The record drop in the pound immediately after the referendum underscores 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 following the result highlights the negative expectations financial market participants held for sterling investments once the outcome became clear, significantly altering the UK GBP to Euro exchange rate.
The substantial falls in the pound in 2017 and 2019 coincided with periods of heightened political uncertainty. These declines also reflected increasingly negative expectations for sterling-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade agreement preceded increases in the pound’s value, demonstrating the sensitivity of the UK GBP to Euro exchange rate to political and economic news.
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 currency valuations like the UK GBP to Euro exchange rate.
Consequences of a Weaker Pound Sterling
One immediate 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. For individuals and businesses dealing with UK GBP to Euro transactions, this means that goods and services priced in Euros become more expensive.
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. This can potentially have positive effects on a country’s trade deficit and overall economic growth. For the UK, a weaker pound could theoretically boost exports to Eurozone countries, although the reality is complex.
Research on the net effect of currency depreciation is inconclusive. Furthermore, persistent uncertainty surrounding the extent and implications of post-Brexit trade frictions complicates the outlook for the UK economy. To fully understand the long-term consequences of the Brexit-related depreciation of the pound and its impact on the UK GBP to Euro exchange rate and the broader economy, further research is necessary.
Expert Insights on Currency Exchange and Brexit Impacts
For deeper insights into currency exchange dynamics and the economic consequences of Brexit, consider exploring the work of these experts:
- 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)
