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 Currency Pound To Euro exchange rate showed the pound being approximately 15% lower than it was on the eve of the vote to leave the European Union (EU) in June 2016. This devaluation is even more stark when considering the 20% drop from when the EU Referendum Act received Royal Assent in December 2015, marking a pivotal moment in the UK’s relationship with Europe.
Over the past five years, Brexit has emerged as a dominant factor influencing the volatility of exchange rates and notably, the value of the pound against major currencies like the euro. The immediate aftermath of the referendum vividly illustrated this impact, with the pound experiencing its most dramatic single-day fall in three decades. Further substantial and sustained declines occurred in 2017 and 2019, pushing the value of sterling to new lows against both the euro and the US dollar by August 2019, as depicted in Figure 1.
This depreciation was largely fueled by expectations of increased trade barriers between the UK and its largest trading partner, the EU. Coupled with heightened uncertainty and persistent political instability, these factors prompted financial institutions to sell off pound-denominated assets. As more institutions divested from sterling, the currency pound to euro rate, and indeed the pound’s value against other currencies, was driven downwards.
Figure 1: Pound/Euro Daily Exchange Rate Trends (2015-2021)
Source: Bloomberg
Decoding Exchange Rate Dynamics: Supply and Demand
An exchange rate is essentially the price of one currency expressed in terms of another. Like any price in a market economy, it fluctuates based on the principles of supply and demand. In the context of the currency pound to euro exchange rate, if demand for pounds decreases relative to the euro, the pound’s value depreciates, and the euro appreciates.
Fundamentally, the weakening of the pound since the Brexit referendum signifies a reduction in the global demand to hold pounds compared to other currencies. Therefore, to fully grasp the underlying reasons for Brexit-related shifts in the currency pound to euro exchange rate, it’s crucial to identify the factors that influence the demand for a currency.
Key Players in Currency Exchange Markets
Organizations engaged in international trade are significant participants in currency markets. This includes businesses involved in import and export activities, as well as individual travelers needing to exchange currency for international travel. For example, when a UK business imports goods from the Eurozone, they need to convert pounds into euros, thus increasing the demand for euros and potentially influencing the currency pound to euro rate. Significant shifts in international trade flows can therefore impact currency demand and valuation.
However, the sharp and rapid depreciation of the pound following 2016 predates any actual changes in the trading relationship between the UK and the EU. Moreover, trade in goods and services isn’t the primary driver of overall foreign exchange transactions and tends to be relatively stable in the short term, according to the Bank for International Settlements (BIS, 2019). This suggests that trade in goods and services may not be the primary cause of the extreme fluctuations in exchange rates, nor the main reason for the Brexit-related decline in the currency pound to euro exchange rate.
A more critical factor behind the pound’s significant depreciation since 2016 is the marked decrease in the preference of financial institutions to hold investments denominated in pounds. The trading of currencies for investment purposes, or financial asset trading, constitutes the largest portion of currency transactions and is typically the most significant driver of exchange rate movements, especially in the short run.
This is often referred to as ‘hot money’ – capital that is highly mobile and can move swiftly between investments or currencies on a large scale, rapidly impacting exchange rates. Consequently, the most influential participants in currency markets are financial institutions, such as banks, securities firms, and institutional investors, who heavily influence the currency pound to euro and other exchange rates.
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, increases its reliance on international capital inflows and makes the pound more susceptible to global capital movements. This is because the current account deficit has been increasingly financed by these capital inflows, making the currency pound to euro rate more sensitive to investor sentiment.
Brexit’s Impact on the Pound’s Appeal
The primary factors that financial institutions consider in currency markets are those that affect the returns on investments in different currencies. The fall in the currency pound to euro rate and the overall value of sterling associated with Brexit indicates that financial market participants anticipated that investments in pound-denominated assets would perform worse after the Brexit vote than they would have otherwise.
Several factors can influence returns in currency markets, and isolating the specific effects is complex. However, some of the most important drivers are typically shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.
Interest Rates Dynamics
Changes in interest rates are widely recognized as a primary driver of exchange rates, including the currency pound to euro rate. Domestic interest rates can significantly impact the relative return on assets in different countries. A decrease in a country’s interest rates makes assets linked to that rate less attractive due to lower returns. An unexpected interest rate cut (assuming other factors remain constant) will lead to reduced demand for those assets compared to assets in other currencies. This, in turn, will cause a depreciation in the value 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 is important to note that this policy adjustment was announced weeks after the Brexit vote. Therefore, the significant drop in the currency pound to euro rate and 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.
Uncertainty and Political Instability Premiums
Changes in risk perception can also profoundly affect expected returns and influence investor decisions regarding which assets (including currencies) to hold. Increased uncertainty surrounding factors like future business performance, economic forecasts, interest rate trajectories, and political stability can make holding assets in a particular currency riskier, leading to reduced or delayed investment inflows. This directly impacts the currency pound to euro exchange rate.
The high probability of increased trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Research conducted before the referendum projected substantial declines in foreign investment in the UK as a consequence of Brexit-related trade costs.
These risks were further compounded by significant and persistent political instability in the UK, which prolonged and deepened uncertainty about post-Brexit trading arrangements and the likely economic outcomes. The most pronounced and sustained falls in the currency pound to euro rate and the pound’s value since 2016 were closely linked to heightened uncertainty and associated political turmoil.
Notably, 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 shortly after Boris Johnson became Prime Minister and did not 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.
The Role of Expectations
The depreciation of the currency pound to euro rate and the pound’s value occurred before Brexit actually materialized. Conversely, exchange rate movements were relatively muted when the UK officially 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 affects expectations about a currency will swiftly be reflected in exchange rates. If market participants anticipate a negative future impact on investments in a currency, they will sell that currency, causing its value to decline, directly impacting the currency pound to euro rate.
The record fall in the pound immediately after the referendum vote 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 after the result highlights the negative expectations that financial market participants had for sterling investments once the outcome became clear.
The substantial declines in the currency pound to euro rate and the pound’s value in 2017 and 2019 occurred during periods of heightened political uncertainty. These declines also reflect 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.
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 forming their expectations, directly influencing decisions on currency pound to euro and other exchange rates.
Consequences of a Weaker Pound
One immediate consequence of a weaker pound, impacting the currency pound to euro exchange for UK citizens, is that imported goods, services, and assets become more expensive. This leads to higher inflation rates and an increased cost of living for UK residents.
However, a weaker currency can also offer benefits by making exports more competitive. By reducing the cost of domestic goods and services for residents of other countries, it can potentially improve a country’s trade deficit and stimulate overall economic growth.
Research on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the magnitude and implications of post-Brexit trade frictions makes the long-term outcome for the UK economy even less clear. Further research is needed to fully understand the long-term consequences of the Brexit-related fall in the currency pound to euro rate and the overall value of sterling.
Further Reading and Expert Insights
For deeper insights into currency exchange rates and the factors influencing them, consider exploring resources from reputable financial institutions and academic publications.
Experts on Currency Exchange Rates and Brexit Impacts
- 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)
