The relationship between the British Pound (GBP) and the Euro (EUR) has been significantly impacted since the UK’s vote to leave the European Union in June 2016. 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. This depreciation is even more pronounced when compared to December 2015, when the EU Referendum Act received Royal Assent, showing a 20% decrease in Sterling’s value.
Brexit has emerged as a central factor influencing the volatility of exchange rates and the value of the pound in contrast to major global currencies over the past half-decade. The immediate aftermath of the referendum vote vividly illustrated this impact, as the pound sterling experienced 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 trend largely stemmed from growing expectations of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and ongoing political instability. These factors prompted financial institutions to sell off pound-denominated assets. As the volume of Sterling sales increased, the pound’s value diminished relative to other currencies, particularly the euro.
The Mechanics of Exchange Rate Changes
An exchange rate represents the price of one currency in terms of another. These rates are dynamic, governed by the principles of supply and demand. In any currency pair, when demand for one currency increases relative to the other, its value will appreciate while the other currency depreciates.
Fundamentally, the weakening of the pound since the Brexit referendum reflects a decrease in the demand to hold pounds compared to other currencies, especially the euro. To fully grasp the Brexit-related fluctuations in the British Pound Vs Euro exchange rate, it’s crucial to identify the underlying factors that influence currency demand.
Key Players in Exchange Rate Dynamics
Participants in international trade, dealing with goods and services, are significant actors in currency markets. This includes multinational corporations engaged in cross-border trade and individual travelers exchanging currencies for international transactions. For instance, when a UK entity purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars. Major shifts in international trade patterns can therefore significantly impact currency demand and valuations.
However, the sharp and rapid depreciation of the pound following 2016 occurred prior to any actual changes in the trade relationship between the UK and the EU. Moreover, the volume of trade in goods and services isn’t the primary driver of overall foreign exchange transactions and typically doesn’t fluctuate dramatically in the short term (Bank for International Settlements, BIS, 2019). This suggests that changes in the trade of goods and services may not be the principal cause of extreme exchange rate volatility, and perhaps not the main reason for the Brexit-induced decline in the pound’s value against the euro.
A more critical factor behind the pound’s sharp depreciation since 2016 is the substantial 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 largest segment of currency transactions and is usually the most significant driver of exchange rate movements, particularly in the short run.
This is often referred to as ‘hot money’ – highly mobile capital that can be rapidly shifted between investments or currencies on a large scale, causing swift exchange rate adjustments. Consequently, the most influential players 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. Direct transactions from non-financial customers represented only 4.9% of the total currency exchange volume (BIS, 2019).
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, leads to a reliance on ‘the kindness of strangers’ and makes the pound more vulnerable to international capital flows. This vulnerability arises because the current account deficit has been increasingly financed by these capital inflows, making the British Pound vs Euro exchange rate sensitive to investor sentiment.
Brexit’s Impact on Pound Sterling’s Appeal
Financial institutions operating in currency markets primarily react to factors that influence the expected returns on investments in different currencies. Therefore, the pound’s depreciation linked to Brexit indicates that financial market participants anticipated that investments in pound-denominated assets would perform less favorably post-Brexit than they would have otherwise.
Numerous factors can potentially affect returns in currency markets, making it challenging to isolate individual effects. However, key drivers typically include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations.
Interest Rates
Interest rate differentials are widely recognized as a primary determinant of exchange rates, including the British Pound vs Euro exchange rate. Domestic interest rates influence the relative attractiveness of assets in different countries. Lower interest rates in a country reduce the yield on assets linked to that rate. An unexpected decrease in interest rates (holding other factors constant) will decrease demand for those assets relative to assets in currencies offering higher returns. This leads to a depreciation of the currency in question.
For example, in response to the Brexit 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 adjustment occurred weeks after the Brexit referendum. Thus, the significant drop in the pound’s value in June 2016, or in subsequent years, cannot be solely attributed to the immediate reaction of financial markets to this specific interest rate change.
Uncertainty and Political Instability
Changes in risk perception also significantly impact expected returns and influence investor decisions regarding currency holdings. Increased uncertainty regarding future business performance, economic prospects, interest rate trajectories, and political stability can make holding assets in a particular currency riskier. This increased risk 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 prior to 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, which prolonged and deepened uncertainty surrounding post-Brexit trade relationships and the anticipated economic outcomes. The most pronounced and sustained declines in the pound since 2016 have been closely correlated with periods of heightened uncertainty and associated political turmoil, impacting the British Pound vs Euro exchange rate.
A notable drop 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 fell to a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister and indicated a willingness to consider a ‘no-deal’ Brexit – widely considered the most adverse 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 (Bloom et al, 2019).
Expectations
The depreciation of the pound largely preceded the actual implementation of Brexit. 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 timing discrepancy highlights the crucial role of investor expectations in driving currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly incorporated into currency markets due to the immense trading volumes and speed of transactions. Any new information that alters expectations about a currency’s future prospects will quickly be reflected in its exchange rate. If market participants anticipate a negative future impact on investments in a particular currency, they will sell that currency, causing its value to fall. This is particularly evident in the British Pound vs Euro exchange rate dynamics.
The record fall of the pound immediately after the referendum underscores the swift impact of shifting market expectations on currencies, as the Leave vote surprised many observers. Pre-referendum polls suggested a likely Remain victory, initially leading to a pound appreciation in the days leading up to the vote. The subsequent collapse in the pound’s value immediately following the result vividly illustrates the negative expectations that financial market participants developed for sterling investments once the outcome became clear.
The significant pound depreciations in 2017 and 2019 occurred during periods of heightened political uncertainty. These declines also reflected increasingly pessimistic expectations for sterling-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, improved optimism regarding an orderly Brexit and a trade agreement preceded increases in the pound’s value.
Recent studies have established specific links between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). These findings suggest that market participants actively consider the level of policy uncertainty when forming their exchange rate expectations, significantly impacting pairs like the British Pound vs Euro.
Consequences of a Weaker Pound
A direct 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.
However, a weaker currency can also offer benefits by making exports more competitive. It reduces the cost of domestic goods and services for international buyers, potentially improving the country’s trade deficit and boosting overall economic growth.
Research examining the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the magnitude and implications of post-Brexit trade frictions adds complexity, making the long-term economic outcome for the UK uncertain. Further research is necessary to fully understand the long-term consequences of the Brexit-related depreciation of the pound and its ongoing impact on the British Pound vs Euro exchange rate.
Further Reading
Expert Contributors
- 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)
Photo by PublicDomainPictures from Pixabay
