The dawn of 2021 painted a stark picture for the British Pound (GBP) against the Euro (EUR). It started approximately 15% weaker than its position on the eve of the UK’s pivotal referendum on European Union (EU) membership in June 2016. Delving further back, Sterling was languishing at a 20% deficit compared to its value when the EU Referendum Act received Royal Assent in December 2015. This dramatic shift underscores the profound impact of Brexit on the GBP to EUR exchange rate, a key concern for businesses, travelers, and economists alike.
The last half-decade has witnessed Brexit emerge as a dominant force shaping exchange rate volatility and the fluctuating value of the pound against major global currencies. The immediate aftermath of the referendum vote served as a stark reminder of this influence, as Sterling endured its most precipitous single-day decline in three decades. This initial shockwave was followed by further substantial and sustained depreciations in 2017 and 2019, culminating in the pound hitting new nadirs against both the euro and the US dollar in August 2019, as visually represented in Figure 1.
This depreciation was largely fueled by mounting expectations of increased trade barriers between the UK and its largest trading partner, coupled with escalating uncertainty and persistent political instability. These factors collectively triggered a sell-off of the pound by financial institutions. As more entities divested from sterling-denominated assets, the pound’s value was inevitably pushed downwards relative to other currencies, most notably the Euro.
Unpacking Exchange Rate Fluctuations: Supply and Demand
An exchange rate, at its core, is simply the price of one currency expressed in terms of another. Like any price in a market economy, it is governed by the fundamental principles of supply and demand. This means that within a currency pair like GBP vs EUR, one currency will appreciate (increase in value) while the other depreciates (decrease in value) based on shifts in demand. Increased demand for one currency coupled with increased selling pressure on the other will cause this fluctuation.
In the context of the post-referendum period, the decline in Sterling’s value signifies a reduced demand to hold pounds relative to other currencies, particularly the Euro. To grasp the underlying reasons for Brexit-induced exchange rate movements in the GBP vs EUR pairing, we must explore the factors that dictate the demand for a currency.
Key Players in Exchange Rate Dynamics
Organizations engaged in international trade of goods and services are crucial and consistent participants in the foreign exchange markets. This encompasses businesses involved in cross-border commerce, as well as individual travelers exchanging currencies for personal expenditures. For instance, when a UK resident or company purchases goods from the United States, they must convert pounds into dollars, thereby augmenting the demand for dollars and potentially influencing the GBP vs USD exchange rate. Significant changes in international trade volumes can thus alter the demand for and valuation of a currency.
However, the rapid and significant drops in Sterling’s value following 2016 occurred before any tangible changes in the trading relationship between the UK and the EU had materialized. Moreover, trade in goods and services constitutes a relatively small fraction of overall foreign exchange transactions and tends to exhibit less volatility in the short term, according to the Bank for International Settlements (BIS) 2019 data. This suggests that shifts in goods and services trade are not the primary drivers behind extreme exchange rate fluctuations and may not be the principal cause of the Brexit-related decline in the GBP vs EUR exchange rate.
A far more critical catalyst for the sharp depreciation of the pound since 2016 is the substantial decrease in the inclination of financial institutions to hold investments denominated in pounds. Trading currencies for investment purposes, or trading in financial assets, constitutes the lion’s share of currency transactions and typically exerts the most significant influence on exchange rate movements, especially in the short run. This is particularly pertinent to understanding GBP vs EUR movements.
This type of investment-driven currency flow is often termed ‘hot money’ – capital that is highly mobile and can swiftly move between investments or currencies on a large scale, causing rapid shifts in exchange rates. Consequently, the most influential players in currency markets are financial institutions such as banks, securities firms, and institutional investors.
In 2019, financial institutions (excluding foreign exchange dealers) accounted for a staggering 57.8% of foreign exchange turnover in the UK. In stark contrast, only 4.9% of currency exchange volume was directly attributable to non-financial customers, as per BIS data from 2019. This highlights the dominant role of financial institutions in shaping exchange rates, including the GBP vs EUR rate.
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, exacerbates its reliance on international capital inflows to fund this deficit. This dynamic renders the pound more susceptible to the ebbs and flows of international capital movements. This vulnerability is particularly relevant when analyzing the GBP vs EUR exchange rate in the context of global economic shifts.
Brexit’s Impact: Why the Pound Lost Its Allure
The primary considerations for financial institutions operating in currency markets are factors that influence the returns on investments denominated in different currencies. Consequently, the Brexit-related depreciation of Sterling suggests that financial market participants anticipated that investments in pound-denominated assets would underperform in the post-Brexit landscape compared to their pre-Brexit trajectory. This sentiment directly impacted the GBP vs EUR valuation.
Numerous factors can potentially impact returns in currency markets, making it challenging to isolate the effects of each. Nevertheless, some of the most influential factors typically 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 widely regarded as primary drivers of exchange rates. This is because domestic interest rates can alter the relative attractiveness of assets in different countries. A decrease in interest rates within a country diminishes the returns on assets linked to that rate. An unexpected reduction in interest rates, holding other variables constant, will lead to a decrease in demand for those assets relative to comparable assets in other currencies. This, in turn, causes a depreciation of the currency in question, directly affecting pairings like GBP vs EUR.
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 crucial to note that this policy adjustment was announced weeks after the Brexit vote. Therefore, the immediate and substantial drop in the pound’s value in June 2016, or in subsequent years, cannot be solely attributed to financial market reactions to this specific interest rate change. While interest rates play a role in GBP vs EUR valuations, the Brexit vote itself had a more immediate impact.
Uncertainty and Political Instability
Shifts in risk perception can also significantly impact expected returns and influence investors’ decisions regarding asset allocation, including currency holdings. Heightened uncertainty surrounding factors like future company performance, economic prospects, interest rate trajectories, and political stability can all elevate the perceived risk of holding assets in a specific currency. This increased risk can curtail or delay investment inflows, thereby impacting the GBP vs EUR exchange rate.
The heightened probability of increased trade frictions between the UK and the EU post-Brexit amplified these risks for assets denominated in pounds. Research conducted prior to the referendum projected substantial declines in foreign investment in the UK as a consequence of Brexit-related trade costs. These projections became a self-fulfilling prophecy, contributing to the weakening of GBP vs EUR.
These risks were further compounded by significant and persistent political instability within the UK. This prolonged and deepened the uncertainty surrounding post-Brexit trading arrangements and the anticipated economic ramifications. The most pronounced and sustained depreciations of the pound since 2016 were closely correlated with periods of heightened uncertainty and associated political turmoil, directly impacting the GBP vs EUR rate.
One of the most significant drops 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 within days of Boris Johnson assuming office as Prime Minister and his refusal to dismiss the possibility of a ‘no-deal’ Brexit – widely considered the most adverse economic scenario for the UK. These political events directly influenced investor sentiment and the GBP vs EUR exchange rate.
Evidence suggests that the negative consequences of this uncertainty for employment, productivity, and investment within UK businesses became increasingly apparent in the years immediately following the referendum. This economic fallout further contributed to the downward pressure on the pound and its valuation against the Euro.
Expectations
The depreciation of Sterling largely predated the actual implementation of Brexit. Conversely, exchange rate fluctuations were relatively muted when the UK formally left the EU and the transition period concluded at the end of 2020. This timing underscores the crucial role of investor expectations in triggering currency movements. Changing investor expectations are rapidly incorporated into currency markets due to the sheer volume and velocity of trading. Any new information that influences expectations about a currency is swiftly reflected in exchange rates, impacting GBP vs EUR and other currency pairs. If market participants anticipate a negative future impact on investments denominated in a particular currency, they will sell off that currency, causing its value to decline.
The record-breaking fall of the pound immediately after the referendum vote vividly illustrates the rapid impact of shifting market expectations on currencies. The Leave vote caught many observers by surprise. Last-minute polls suggested a likely Remain victory, initially causing Sterling to appreciate in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately after the result starkly reveals the negative expectations that financial market participants harbored for sterling investments once the outcome became clear, heavily influencing the GBP vs EUR exchange rate.
The significant drops in the pound in 2017 and 2019, impacting GBP vs EUR, coincided with periods of heightened political uncertainty. These declines also reflect increasingly pessimistic expectations for sterling-denominated investments driven by the growing likelihood of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade agreement preceded appreciations in the pound’s value. This demonstrates the direct link between Brexit-related news and the GBP vs EUR exchange rate.
Recent research has established specific links between economic policy uncertainty and exchange rate expectations. Findings indicate that market participants factor in the level of policy uncertainty when formulating their expectations, which directly impacts currency valuations like GBP vs EUR.
Consequences of Sterling’s Depreciation
One immediate consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK residents. This translates to higher inflation rates and an elevated cost of living. This inflationary pressure is a direct consequence of the GBP vs EUR depreciation and affects consumers directly.
However, a weaker currency can also offer potential benefits. It can enhance export competitiveness by reducing the cost of domestic goods and services for residents of other countries. This could potentially have positive implications for the country’s trade deficit and overall economic growth. However, the extent of these benefits in the post-Brexit context is uncertain.
Research examining the net effect of currency depreciation is, at best, inconclusive. Furthermore, uncertainty surrounding the magnitude and implications of post-Brexit trade frictions persists, obscuring the likely long-term outcome for the UK economy and the sustained impact on the GBP vs EUR exchange rate. To fully understand the long-term consequences of the Brexit-related fall in Sterling, further research and analysis are essential.
Further Exploration
For deeper insights into currency exchange dynamics and the impact of Brexit on the UK economy, numerous resources are available from reputable financial institutions and academic bodies.
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)
Author: Christopher Coyle
Photo by PublicDomainPictures from Pixabay
Figure 1: Daily fluctuations in the Pound to Euro exchange rate between 2015 and 2021, highlighting the volatility around key Brexit events.
