Since the UK’s vote to leave the European Union in June 2016, the Currency Exchange Rate Sterling To Euro has become a closely watched economic indicator. At the beginning of 2021, the British pound (sterling) was approximately 15% weaker against the euro compared to its position on the eve of the Brexit referendum. This depreciation is even more stark when considering the period before the EU Referendum Act in December 2015, with sterling being 20% weaker.
Brexit has emerged as a dominant factor influencing the volatility of exchange rates and the value of the pound against major global currencies over the past five years. The immediate aftermath of the referendum vote vividly demonstrated this impact, as sterling experienced its most significant single-day drop in three decades. Further substantial and sustained declines occurred in 2017 and 2019, pushing the value of sterling to new lows against both the euro and the US dollar by August 2019, as illustrated in Figure 1.
This depreciation largely stemmed from 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, driving down the value of the pound relative to other currencies as more organizations divested from sterling.
Figure 1: Pound/Euro daily exchange rate 2015-2021
Source: Bloomberg
Understanding the Dynamics of Exchange Rate Fluctuations
An exchange rate represents the price of one currency in relation to another. These rates are not static; they fluctuate based on the fundamental principles of supply and demand. In any currency pair, when demand for one currency increases while the other is sold off, the former will appreciate in value, and the latter will depreciate.
The post-referendum decline in the value of sterling signifies a reduced demand for holding pounds compared to other currencies. To fully grasp the underlying causes of these Brexit-related exchange rate movements, it’s essential to identify the factors that influence the demand for a currency.
Key Players in Currency Exchange Rate Shifts
Organizations engaged in international trade of goods and services are significant participants in currency markets. This includes multinational corporations conducting cross-border sales and individual travelers exchanging currency for personal expenses. For instance, when a UK entity imports goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars in the currency exchange rate. Significant shifts in international trade patterns can thus alter the demand for and value of a currency.
However, the rapid and substantial depreciation of sterling post-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 changes in goods and services trade might not be the primary cause of extreme exchange rate volatility and may not fully explain the Brexit-related decline in sterling’s value.
A critical factor behind the sharp falls in the pound’s value since 2016 is the significant decrease in financial institutions’ preference 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 generally the most significant driver of exchange rate changes, particularly in the short term.
This is often referred to as ‘hot money’ – highly mobile capital that can swiftly move between investments or currencies, exerting rapid and substantial influence on exchange rates. Consequently, the most influential participants in currency markets are financial institutions, including 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. Conversely, 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 reliance on external financing and makes the pound more susceptible to international capital movements. This vulnerability arises because the current account deficit has become increasingly reliant on these capital inflows.
Brexit’s Impact on Sterling’s Attractiveness in Currency Exchange
The primary factors influencing financial institutions’ decisions in currency markets are those that affect the returns on investments in different currencies. Consequently, the Brexit-related depreciation of sterling suggests that financial market participants anticipated poorer performance for pound-denominated investments post-Brexit.
Numerous factors can influence returns in currency markets, and isolating the impact of each is complex. However, key factors typically include changes in relative interest rates, risk perceptions, and overall investor expectations.
Interest Rates
Changes in interest rates are widely recognized as a primary driver of exchange rates. Domestic interest rates can impact the relative returns on 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 (holding other factors constant) leads to decreased demand for those assets relative to similar assets in other currencies, causing a depreciation of the currency in question.
For instance, 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 vote. Therefore, the significant drop in sterling’s value in June 2016, or in subsequent years, cannot be solely attributed to financial market participants’ reaction to this specific interest rate cut.
Uncertainty and Political Instability
Changes in risk perception can also affect expected returns and influence investment decisions across currencies. Increased uncertainty surrounding factors like future company performance, economic outlook, interest rates, and political stability can elevate the perceived risk of holding assets in a specific currency. 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. Pre-referendum research 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, prolonging and deepening uncertainty about post-Brexit trading arrangements and the likely economic consequences. The most substantial and sustained falls in the pound since 2016 were closely linked to increased uncertainty and associated political turmoil.
One of the most significant depreciations of sterling 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 worst-case economic scenario for the UK.
Evidence suggests that the negative consequences of this uncertainty for 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 sterling largely occurred before Brexit officially took place. Conversely, exchange rate movements were relatively minor when the UK formally left the EU and the transition period concluded at the end of 2020. This timing highlights the crucial role of investor expectations in triggering currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly incorporated into currency markets due to the high volume and speed of trading. Any new information impacting expectations about a currency is quickly reflected in exchange rates. If market participants anticipate negative future implications for investments in a currency, they will sell that currency, causing its value to decline.
The record fall of the pound after the referendum illustrates the swift impact of shifting market expectations on currencies, as the Leave vote surprised many observers. Last-minute polls suggested a likely 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 financial market participants held regarding sterling investments once the outcome was clear.
The significant falls in the pound in 2017 and 2019 occurred during periods of heightened political uncertainty. These depreciations also 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 agreement preceded increases in the pound’s value.
Recent research has demonstrated specific links 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.
Consequences of Sterling’s Depreciation in Currency Exchange Rates
A direct consequence of a weaker sterling 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 be advantageous by making exports more competitive. Lowering the cost of domestic goods and services for international buyers can potentially improve a country’s trade deficit and contribute to 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 outcome for the UK economy unclear. Further research is needed to fully understand the long-term consequences of the Brexit-related fall in sterling and its impact on the currency exchange rate sterling to euro.
Further Resources
For deeper insights into this topic, consider exploring resources from organizations like the Bank of England, the London School of Economics, and academic publications focusing on international finance and economics.
Experts in the Field
To further your understanding, consider researching the work of these 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)
