Since the UK’s vote to leave the European Union in June 2016, the exchange rate between the pound sterling and the euro has experienced significant volatility. At the beginning of 2021, the pound was approximately 15% weaker against the euro compared to its value before the referendum. This represents a substantial shift in the value of 1 Pound Sterling To Euro, impacting businesses, travelers, and the broader UK economy. Examining the factors behind these fluctuations is crucial to understanding the post-Brexit economic landscape.
The referendum on the UK’s EU membership in June 2016 marked a turning point. Even prior to the actual vote, as the EU Referendum Act received Royal Assent in December 2015, sterling was already 20% weaker than its earlier position. This initial weakening signaled market anticipation of potential economic shifts. However, the immediate aftermath of the referendum triggered the most dramatic movement. The pound sterling experienced its largest single-day drop in 30 years following the vote, highlighting the profound impact of Brexit on currency markets.
The years following the initial shock saw further periods of decline. Substantial and sustained falls in 2017 and 2019 pushed the value of sterling to new lows against both the euro and the dollar. By August 2019, the exchange rate reflected the culmination of ongoing market adjustments to the evolving Brexit situation. Figure 1 visually represents these fluctuations in the pound/euro daily exchange rate from 2015 to 2021, clearly illustrating the periods of significant decline.
This depreciation of the pound against the euro and other currencies is primarily attributed to the anticipation of increased trade barriers between the UK and the EU, its largest trading partner. The uncertainty surrounding the future relationship, coupled with persistent political instability in the UK, led financial institutions to reduce their holdings of pound-denominated assets. As these institutions sold off sterling, the increased supply in the market drove down its value relative to other currencies, including the euro.
Decoding Exchange Rate Dynamics: Supply and Demand
To understand why Brexit had such a profound effect on the 1 pound sterling to euro exchange rate, it’s essential to grasp the fundamental principles governing exchange rate movements. An exchange rate is essentially the price of one currency in relation to another. Like any price in a market economy, it is determined by the forces of supply and demand.
When demand for a particular currency increases, its value appreciates, meaning it takes more of another currency to buy it. Conversely, when demand decreases, the currency depreciates, and it takes less of another currency to buy it. In the context of the pound sterling’s decline since the Brexit referendum, this signifies a decrease in the global demand to hold pounds compared to currencies like the euro.
Therefore, to fully understand the Brexit-related exchange rate movements and their impact on the 1 pound sterling to euro rate, we need to identify the factors that influence the demand for a currency in the global market. These factors are complex and multifaceted, extending beyond simple trade transactions.
Key Players in Currency Exchange: Beyond Trade
While international trade in goods and services plays a role in currency markets, it is not the primary driver of short-term exchange rate fluctuations, particularly the dramatic shifts observed after the Brexit referendum. Companies engaged in international trade and individual travelers converting currency for personal use are indeed participants in the market. For instance, when a UK company imports goods from the Eurozone, they need to convert pounds into euros, increasing the demand for euros and potentially influencing the 1 pound sterling to euro exchange rate.
However, the rapid and substantial falls in the value of sterling occurred before any significant changes in the actual trading relationship between the UK and the EU had taken place. Furthermore, data indicates that trade in goods and services constitutes a relatively small portion of overall foreign exchange transactions. The Bank for International Settlements (BIS) reports that it is not the primary source of these massive foreign exchange transactions and typically doesn’t change rapidly in the short term.
The dominant force behind the sharp depreciation of the pound since 2016 is the significant shift in the investment preferences of financial institutions. The trading of currencies for investment purposes, or the trade in financial assets, constitutes the largest share of currency transactions and is generally the most influential factor driving exchange rate changes, especially in the short run.
This type of capital movement is often referred to as “hot money” – funds that are highly mobile and can be quickly moved between investments or currencies on a large scale. This rapid movement has a direct and immediate impact on exchange rates. Consequently, the most influential participants in currency markets are large financial institutions, including banks, securities firms, and institutional investors. BIS data from 2019 shows that financial institutions (excluding foreign exchange dealers) accounted for 57.8% of foreign exchange turnover in the UK, while non-financial customers were directly responsible for only 4.9%.
Adding to the pound’s vulnerability, the UK’s persistent current account deficit, where imports consistently exceed exports, increases its reliance on international capital inflows. This reliance, sometimes referred to as dependence on the “kindness of strangers,” makes the pound more susceptible to the movements of international capital and the sentiments of these large financial players.
Brexit’s Impact on Pound Sterling’s Appeal: Investor Confidence
The decline in the value of sterling following the Brexit vote suggests a fundamental shift in how financial markets perceived the attractiveness of investments denominated in pounds. Financial institutions, the key drivers of exchange rate movements, respond primarily to factors that influence the expected return on investments in different currencies. Brexit introduced several factors that negatively impacted these expected returns for pound-denominated assets.
While isolating the individual effects of these factors is complex, key drivers typically include changes in relative interest rates, perceived risk, and overall investor expectations. All of these were significantly affected by the Brexit vote and subsequent political and economic developments.
Interest Rates
Changes in interest rates are widely recognized as a primary driver of exchange rates. Domestic interest rates influence the relative return on assets in different countries. A decrease in interest rates in a country makes assets linked to that rate less attractive compared to similar assets in currencies with higher interest rates. An unexpected interest rate cut, all else being equal, will lead to reduced demand for those assets and consequently a fall in the value of the currency.
In response to the Leave vote, the Bank of England did reduce interest rates in August 2016, from 0.5% to 0.25%, and expanded its quantitative easing (QE) program. However, this policy change was announced weeks after the initial Brexit vote. Therefore, the immediate and sharp fall in the pound sterling to euro exchange rate in June 2016 cannot be solely attributed to this specific interest rate adjustment. The market reaction was more anticipatory and based on broader concerns.
Uncertainty and Political Instability
Changes in perceived risk significantly impact expected returns and investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors like future economic performance, company prospects, interest rate trajectories, and political stability makes holding assets in a specific currency riskier. This heightened risk perception can lead to reduced or delayed investment inflows.
Brexit significantly amplified these risks for assets denominated in pounds. The increased likelihood of greater trade frictions between the UK and the EU post-Brexit created economic uncertainty. Pre-referendum research predicted substantial declines in foreign investment in the UK due to Brexit-related trade costs.
These economic risks were further compounded by significant and persistent political instability in the UK. Prolonged uncertainty surrounding post-Brexit trading arrangements and the overall economic outlook fueled market anxieties. The most substantial and sustained falls in the pound sterling to euro exchange rate since 2016 coincided with periods of heightened uncertainty and political turmoil.
For example, 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, further increasing political uncertainty. In 2019, the pound fell to new multi-year lows against both the dollar and the euro shortly after Boris Johnson became Prime Minister and raised the specter of a “no-deal” Brexit. A no-deal Brexit was widely considered the worst-case economic scenario for the UK, intensifying negative market sentiment.
Evidence suggests that the negative consequences of this uncertainty were increasingly apparent in the years immediately following the referendum, impacting employment, productivity, and investment in UK businesses.
Expectations
Interestingly, the most significant depreciation of the pound occurred before Brexit actually took place. In contrast, exchange rate movements were relatively muted when the UK officially left the EU and the transition period ended at the close of 2020. This highlights the crucial role of investor expectations in driving currency movements.
Currency markets are highly efficient at incorporating changing investor expectations due to the sheer 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 a negative future impact on investments in a particular currency, they will sell that currency, causing its value to fall.
The record fall in the pound immediately after the referendum vividly illustrates the rapid impact of shifting market expectations. Pre-vote polls suggested a likely Remain victory, which had initially caused sterling to appreciate in the days leading up to the referendum. The subsequent collapse in the pound’s value upon the Leave result becoming clear underscores the negative expectations that financial market participants developed for sterling investments in the wake of Brexit.
Similarly, the significant falls in the pound in 2017 and 2019 occurred during periods of heightened political uncertainty, reflecting increasingly negative expectations for sterling-denominated investments due to the growing probability of a “hard” Brexit. Conversely, periods of improved optimism regarding an orderly Brexit and a potential trade deal were often preceded by increases in the pound’s value.
Research has established clear links between economic policy uncertainty and exchange rate expectations, demonstrating that market participants factor in the level of policy uncertainty when forming their outlook and making investment decisions.
Consequences of a Weaker Pound Sterling: Economic Repercussions
One immediate and direct consequence of a weaker pound sterling is that imported goods, services, and assets become more expensive for UK residents. This translates to higher levels of inflation and an increased cost of living, directly impacting consumers’ purchasing power. For individuals and businesses importing goods or traveling abroad, the reduced value of 1 pound sterling to euro means paying more for the same goods or services.
However, a weaker currency can also offer potential benefits. It can make exports more competitive by reducing the cost of domestic goods and services for buyers in other countries. This can potentially improve a country’s trade deficit and stimulate overall economic growth by boosting export volumes.
Nevertheless, research on the net effect of currency depreciation, particularly in the context of Brexit, is inconclusive. The ongoing uncertainty surrounding the extent and implications of post-Brexit trade frictions makes the long-term economic outcome for the UK even more uncertain. Further research is needed to fully understand the longer-term consequences of the Brexit-related fall in sterling and its sustained impact on the UK economy.
Further Resources and Expertise
For those seeking deeper insights into this topic, several experts and resources are available:
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)
Further Reading:
- Bank for International Settlements (BIS) publications on foreign exchange markets.
- Centre for Economic Performance (CEP), London School of Economics research on Brexit.
- Bank of England working papers on Brexit and its economic impact.
- Financial Times articles on pound sterling and Brexit.
By examining the interplay of political events, market expectations, and economic fundamentals, we can gain a more comprehensive understanding of the fluctuations in the 1 pound sterling to euro exchange rate and its broader implications for the UK economy in the post-Brexit era.
