Understanding the British Pound to Euro Exchange Rate: Brexit and Beyond

The relationship between the British Pound (GBP) and the Euro (EUR) has been significantly shaped by the UK’s departure from the European Union. As we entered 2021, the pound’s value was approximately 15% lower against the euro compared to its position before the 2016 Brexit referendum. This represents a substantial shift in the Currency British Pound To Euro exchange rate and reflects broader economic and political factors at play. Furthermore, when considering the enactment of the EU Referendum Act in December 2015, the pound was even weaker, sitting at a 20% deficit.

The past five years have seen Brexit emerge as a dominant force influencing the volatility of exchange rates and the pound’s value against major global currencies. The immediate aftermath of the referendum vote vividly demonstrated this impact, with sterling experiencing 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 illustrated in Figure 1. This depreciation largely stemmed from growing expectations of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and persistent political instability. These factors prompted financial institutions to sell off pound-denominated assets, driving down the pound’s value relative to other currencies as selling pressure mounted.

The Mechanics of Exchange Rate Fluctuations

To grasp the dynamics of the currency british pound to euro exchange rate, it’s crucial to understand the fundamental principles governing exchange rate changes. Essentially, an exchange rate represents the price of one currency in relation to another. Like any price in a market economy, it fluctuates based on the forces of supply and demand. In currency exchange, when demand for one currency within a pair increases while the other’s decreases, the former appreciates in value, and the latter depreciates.

The post-referendum decline in sterling’s value signifies a reduced demand for holding pounds compared to other currencies. Therefore, to understand the Brexit-related shifts in the currency british pound to euro exchange rate, we need to identify the underlying factors that influence the demand for a currency.

Key Players in Currency Exchange Markets

Participants in international trade, dealing with goods and services, are significant actors in currency markets. This includes businesses engaged in cross-border sales and individual travelers exchanging currencies for personal expenses. For instance, when a UK resident or company purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars. Significant shifts in international trade patterns can, therefore, influence the demand and value of a currency.

However, the rapid and considerable depreciation of sterling since 2016 preceded 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 typically doesn’t exhibit sharp short-term fluctuations (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade might not be the primary cause of the extreme exchange rate volatility and may not fully explain the Brexit-related fall in the currency british pound to euro rate.

A critical factor behind the sharp declines in the pound’s value since 2016 is a substantial decrease in the inclination 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 term.

This type of capital is often referred to as ‘hot money’ – highly mobile funds that can swiftly move 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.

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).

Adding to the pound’s vulnerability, the UK’s persistent trade deficit, where imports consistently exceed exports, increases reliance on international capital inflows. This current account deficit has been increasingly funded by these capital inflows, making the pound more susceptible to the movements of international capital.

Brexit’s Impact on the Pound’s Appeal

The decline in the pound’s value following Brexit indicates that financial market participants perceived investments in pound-denominated assets as less attractive post-Brexit. Financial institutions respond to factors that influence the returns on investments in different currencies. Therefore, the shifts in the currency british pound to euro exchange rate reflect changing perceptions of investment returns.

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

Changes in interest rates and factors influencing them are considered primary drivers of exchange rates, including the currency british pound to euro rate. Domestic interest rates can affect the relative return on assets in different countries. A decrease in a country’s interest rates reduces the returns on assets linked to that rate. An unexpected interest rate cut (holding other factors constant) leads 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 significant drop in the pound’s value in June 2016, or in subsequent years, cannot be solely attributed to financial market reactions to this specific interest rate adjustment.

The Role of Uncertainty and Political Instability

Changes in risk perception also significantly impact expected returns and influence investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors like future company performance, economic forecasts, interest rates, and political stability can make holding assets in a specific currency riskier. This heightened risk can reduce or delay investment inflows.

The increased likelihood of trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Research conducted before the referendum 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, prolonging and deepening uncertainty about post-Brexit trading relationships and the likely economic outcomes. The most substantial and sustained falls in the pound since 2016 were closely linked to increased uncertainty and associated political turmoil.

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, particularly due to his refusal to rule out a no-deal Brexit. A no-deal Brexit was 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 pound’s depreciation largely occurred before Brexit actually took place. In contrast, exchange rate movements were relatively minor when the UK officially 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.

Rapidly changing investor expectations are quickly incorporated into currency markets due to the immense volume and speed of trading. Any new information affecting currency expectations is swiftly reflected in exchange rates, including the currency british pound to euro rate. If market participants anticipate negative future impacts on investments in a currency, they will sell that currency, causing its value to decline.

The record fall in the pound after the referendum underscores the rapid impact of shifting market expectations on currencies. The Leave vote surprised many commentators, with last-minute polls suggesting 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 revealed the negative expectations financial market participants held for sterling investments once the outcome was clear.

The significant pound declines in 2017 and 2019 during periods of heightened political uncertainty also reflected increasingly negative expectations for sterling-denominated investments due to 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 the level of policy uncertainty when forming their expectations about currencies like the British Pound and the Euro.

Consequences of a Weaker Pound

One immediate consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK residents. This leads to higher inflation rates and an increased cost of living. For individuals and businesses dealing with the currency british pound to euro, this means that goods and services priced in euros become more expensive when converted to pounds.

However, a weaker currency can also offer benefits. It can enhance export competitiveness by reducing the cost of domestic goods and services for residents of other countries. This can potentially improve a country’s trade deficit and overall economic growth.

Research on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions makes the long-term economic outlook for the UK even more uncertain. Further research is needed to fully understand the long-term consequences of the Brexit-related fall in sterling and its impact on the currency british pound to euro relationship.