The journey of the British pound against the euro since the 2016 Brexit referendum has been marked by significant volatility and a general downward trend. At the beginning of 2021, the pound was notably weaker, approximately 15% lower against the euro compared to its value right before the referendum vote in June 2016. This represents an even starker 20% decrease from its position when the EU Referendum Act was enacted in December 2015.
Brexit has undeniably been a central force driving fluctuations in the exchange rate and the overall value of the pound sterling in relation to major global currencies over the past half-decade. The immediate aftermath of the referendum vividly illustrated this impact, as the pound experienced its most dramatic single-day drop in 30 years. 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 depreciation was largely attributed to growing anticipation 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 this trend intensified, the value of the pound inevitably decreased relative to other currencies like the euro.
Understanding Exchange Rate Dynamics
An exchange rate is fundamentally the price of one currency expressed in terms of another. Its fluctuations are governed by the basic principles of supply and demand. In any currency pair, when demand for one currency increases and supply of the other rises, the former appreciates in value while the latter depreciates.
The post-referendum decline in the pound’s value essentially reflects a decrease in the global demand to hold pounds compared to other currencies. To fully grasp the underlying causes of these Brexit-related exchange rate shifts, we need to examine the factors that influence the demand for a particular currency.
Key Players in Exchange Rate Movements
Businesses engaged in international trade are significant participants in the currency exchange markets. This includes companies involved in import and export activities and individual travelers exchanging currencies for various needs. For instance, when a UK business or resident purchases goods from the Eurozone, they must convert pounds into euros, thereby increasing the demand for euros. Major shifts in international trade volumes can indeed alter the demand for and valuation of a currency.
However, the sharp and rapid depreciation of the pound since 2016 occurred before any actual changes in the trade relationship between the UK and the EU had materialized. Moreover, the volume of trade in goods and services is not the primary driver of overall foreign exchange transactions, and it typically doesn’t change drastically in the short term (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade are not the primary cause of the extreme exchange rate volatility observed and may not be the main reason for the Brexit-related pound depreciation.
A more critical factor behind the pound’s sharp decline since 2016 is a significant reduction in the preference of financial institutions to hold investments denominated in pounds. Currency trading for investment purposes, involving financial assets, constitutes the largest segment of currency transactions and is typically the most influential driver of exchange rate changes, particularly in the short run.
This type of investment-driven currency movement is often referred to as ‘hot money’ – capital that is highly mobile and can swiftly move between investments or currencies on a large scale, causing rapid exchange rate fluctuations. 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. 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 consistently exceed exports, increases its reliance on international capital flows and makes the pound more susceptible to global capital movements. This vulnerability arises because the ongoing current account deficit has been increasingly financed by these capital inflows.
Brexit’s Impact on Pound Sterling’s Appeal
The primary factors that financial institutions consider in currency markets are those that affect the expected returns on investments in different currencies. Therefore, the Brexit-related decline in the pound’s value indicates that financial market participants believed that investments in pound-denominated assets would perform less favorably following the vote to leave the EU than they would have otherwise.
Numerous factors can influence returns in currency markets, and isolating the specific impact of each is complex. However, some of the most significant factors typically include changes in relative interest rates, shifts in perceived risk, and alterations in overall investor expectations.
Interest Rates and Currency Conversion
Changes in interest rates, or factors influencing them, are considered major drivers of exchange rates. Domestic interest rates can impact the relative attractiveness of assets in different countries. Lower interest rates in a country reduce the returns on assets linked to that rate. An unexpected decrease in interest rates, assuming other factors remain constant, will lead to reduced demand for those assets compared to similar assets in currencies offering higher returns. This, in turn, causes a depreciation of the currency in question.
For example, following 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 referendum. Therefore, 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 adjustment.
Uncertainty and Political Instability Impacting GBP to EUR Conversion
Changes in perceived risk also affect expected returns and influence investor decisions about which assets, including currencies, to hold. Increased uncertainty surrounding factors such as 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 (Pindyck, 1991).
The heightened probability 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 intensified uncertainty surrounding post-Brexit trade relationships and the anticipated economic outcomes. The most substantial and sustained declines in the pound since 2016 were closely linked to periods of increased uncertainty and associated political turmoil.
One of the most significant drops in the pound’s value against the euro occurred in 2017. This followed 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 the possibility of 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 within UK businesses became increasingly apparent in the years immediately following the referendum (Bloom et al, 2019).
The Role of Expectations in Currency Value
Crucially, the depreciation of the pound largely occurred before Brexit actually took place. Conversely, exchange rate movements were relatively muted when the UK formally left the EU and the transition period concluded at the end of 2020. This timing highlights the significant 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 sheer volume and speed of trading. Any new information that affects expectations regarding a currency is quickly reflected in its exchange rate. If market participants anticipate a negative future impact on investments in a currency, they will sell that currency, causing its value to fall.
The record drop in the pound immediately after the referendum demonstrates the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many analysts. Last-minute polls suggested a likely Remain victory, initially causing the pound to appreciate in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately after the result announcement underscores the negative expectations that financial market participants developed for pound investments once the outcome became clear.
The substantial pound declines in 2017 and 2019 coincided with periods of heightened political uncertainty. These drops also reflect increasingly negative expectations for investments denominated in pounds, driven by the growing likelihood of a hard Brexit. Conversely, increased optimism regarding an orderly Brexit and a potential trade deal preceded periods of appreciation in the pound’s value.
Recent research has established specific connections between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). Findings indicate that market participants factor in the level of policy uncertainty when forming their expectations about currency values.
Consequences of Pound Sterling Depreciation
A direct consequence of a weaker pound is that goods, services, and assets from overseas become more expensive for UK residents. This leads to increased inflation and a higher cost of living.
However, a weaker currency can also offer advantages by making exports more competitive. By reducing the cost of domestic goods and services for buyers in other countries, it can potentially improve a country’s trade deficit and stimulate 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 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 depreciation of the pound sterling and its impact on the Conversion British Pound Euro rate.
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
