The relationship between the pound sterling and the euro has been significantly shaped by the UK’s decision 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 reflects a complex interplay of economic factors and market sentiment in the wake of Brexit. To truly understand the dynamics of the Pound Sterling Vs Euro exchange rate, it’s crucial to analyze the key events and economic principles at play.
Over the past five years, Brexit has emerged as a dominant factor influencing the volatility of exchange rates and the pound’s value against major currencies, particularly the euro. The immediate aftermath of the 2016 referendum witnessed the most dramatic impact, with sterling experiencing its largest single-day drop in 30 years. Further significant and sustained declines occurred in 2017 and 2019, pushing the pound to new lows against both the euro and the dollar by August 2019.
This depreciation was largely driven by market anticipation of increased trade barriers between the UK and the EU, its largest trading partner. The resulting uncertainty and persistent political instability led financial institutions to divest from the pound. As institutions sold sterling-denominated assets, the pound’s value decreased relative to other currencies, including the euro.
Decoding Exchange Rate Dynamics: Supply and Demand
An exchange rate represents the price of one currency in relation to another. Like any price in a market economy, it is governed by the laws of supply and demand. In the context of pound sterling vs euro, if demand for the pound increases while demand for the euro decreases (or vice versa), the exchange rate will shift to reflect this change. When demand for a currency rises, its value appreciates; conversely, when demand falls, its value depreciates.
The post-referendum decline in the pound’s value signals a decrease in the demand to hold sterling relative to other currencies. To fully grasp the fundamental reasons behind Brexit-related exchange rate movements between the pound and the euro, we need to identify the factors that influence currency demand.
Key Players in Exchange Rate Movements
Participants in international trade of goods and services are significant actors in currency markets. This includes multinational corporations engaged in cross-border trade and individual travelers exchanging currency for personal use. For instance, when a UK business imports goods from the Eurozone, they must convert pounds into euros, thereby increasing the demand for euros and potentially impacting the pound sterling vs euro exchange rate. Large shifts in international trade flows can therefore alter the demand for and value of a currency.
However, the rapid and substantial falls in the pound’s value since 2016 occurred before any actual changes to the UK-EU trading relationship were implemented. Moreover, 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. This suggests that shifts in the trade of goods and services are not the main cause of extreme exchange rate fluctuations and may not be the primary reason for the Brexit-related depreciation of the pound against the euro.
A more critical factor behind the sharp declines in the pound’s value since 2016 is the significant reduction in the willingness of financial institutions to hold investments denominated in pounds. The trading of currencies for investment purposes, or trade in financial assets, constitutes the largest share of currency transactions and is generally the most significant driver of exchange rate changes, particularly in the short run.
This “hot money” – highly mobile capital that can move rapidly between investments or currencies – exerts a powerful influence on exchange rates. Consequently, the most influential participants in currency markets are financial institutions such as banks, investment firms, and institutional investors.
In 2019, financial institutions (excluding foreign exchange dealers) accounted for 57.8% of foreign exchange turnover in the UK, while only 4.9% of currency exchange volume was directly attributed to non-financial customers.
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, increases its reliance on international capital inflows to finance this deficit. This makes the pound more susceptible to the fluctuations of international capital flows and can amplify movements in the pound sterling vs euro exchange rate.
Brexit’s Impact on the Pound’s Appeal
Financial institutions, the dominant players in currency markets, primarily react to factors that affect the returns on investments in different currencies. The Brexit-induced decline in the pound’s value suggests 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 their individual effects is challenging. However, key drivers typically include changes in relative interest rates, shifts in risk perception, and evolving investor expectations.
Interest Rate Dynamics
Interest rate changes, or factors influencing interest rates, are considered major drivers of exchange rates like pound sterling vs euro. Domestic interest rates can impact the relative attractiveness of assets in different countries. A decrease in interest rates in a country reduces the returns 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 assets in other currencies, causing the currency’s value to fall.
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 substantial drop in the pound’s value in June 2016, and in subsequent years, cannot be solely attributed to financial market reactions to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in perceived risk can also significantly affect expected returns and influence investor decisions regarding asset and currency holdings. Increased uncertainty surrounding factors such as future business performance, economic prospects, interest rate trajectories, and political stability can make holding assets in a specific currency riskier. This heightened risk perception can reduce or delay investment inflows, impacting the pound sterling vs euro exchange rate.
The increased likelihood of trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Pre-referendum research predicted substantial declines in foreign investment in the UK due to Brexit-related trade costs.
These risks were further compounded by significant and persistent political instability in the UK. This prolonged uncertainty surrounding post-Brexit trade relationships and the likely economic outcomes. The most substantial and persistent falls in the pound since 2016 coincided with periods of heightened uncertainty and associated political turmoil.
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 multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister, particularly due to his refusal to 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 on employment, productivity, and investment in UK businesses became increasingly apparent in the years immediately following the referendum.
The Power of Expectations
The depreciation of the pound largely preceded the actual implementation of Brexit. Interestingly, exchange rate movements were relatively muted when the UK formally left the EU and the transition period concluded at the end of 2020. This highlights the crucial role of investor expectations in triggering currency movements.
Due to the immense volume and speed of trading, currency markets rapidly incorporate changing investor expectations. Any new information that alters expectations about a currency’s future prospects will quickly be reflected in exchange rates. If market participants anticipate negative future effects 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 exemplifies the rapid impact of shifting market expectations on currencies. The Leave vote surprised many, as last-minute polls suggested a 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 underscores the negative expectations that financial market participants held for sterling investments once the outcome became clear.
The substantial falls in the pound in 2017 and 2019 during periods of increased political uncertainty further 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 deal led to increases in the pound’s value.
Recent research has established specific links between economic policy uncertainty and exchange rate expectations, suggesting that market participants factor in policy uncertainty when forming their expectations about currency values like the pound sterling vs euro rate.
Consequences of Sterling’s Depreciation
A direct consequence of a weaker pound is that foreign goods, services, and assets become more expensive for UK residents. This translates to higher inflation and an increased 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 could potentially improve the country’s trade deficit and contribute to overall economic growth.
Research on the net impact of currency depreciation is inconclusive. Furthermore, the lingering uncertainty surrounding the extent and implications of post-Brexit trade frictions complicates the outlook for the UK economy. Understanding the long-term consequences of the Brexit-related fall in sterling against the euro requires further in-depth research.
Further Resources
- Bank for International Settlements (BIS) Reports
- Research from the Centre for Economic Performance (CEP), London School of Economics
- Bank of England Publications
Experts on Exchange Rates and Brexit Impact
- 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)
