British Pound vs. Euro: Understanding Exchange Rate Fluctuations Post-Brexit

Since the beginning of 2021, the British pound has remained significantly weaker against the euro compared to its pre-Brexit referendum strength in June 2016. In fact, the pound’s value was approximately 15% lower against the euro than it was before the vote on the UK’s EU membership. This depreciation extends even further back, with Sterling being 20% weaker than when the EU Referendum Act was enacted in December 2015.

Brexit has undeniably emerged as a dominant factor influencing the volatility of exchange rates and the pound’s value against major 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 three decades. Further significant and sustained declines occurred in 2017 and 2019, driving the pound to new lows against both the euro and the dollar by August 2019, as illustrated in Figure 1.

This trend was largely fueled by 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, leading to a decrease in the pound’s value relative to other currencies as selling pressure mounted.

The Mechanics of Exchange Rate Movements

An exchange rate essentially represents the price of one currency in relation to another. Like any price, it is governed by the fundamental principles of supply and demand. In a currency pair, when demand for one currency increases while demand for the other decreases, the former will appreciate in value, and the latter will depreciate.

The post-referendum decline in the pound’s value indicates a reduced demand for holding pounds compared to other currencies. Therefore, understanding the underlying causes of Brexit-related exchange rate fluctuations necessitates identifying the factors that influence the demand for a currency.

Key Players in Currency Exchange Markets

Businesses engaged in international trade of goods and services are significant and well-known participants in currency markets. This includes companies involved in cross-border sales and individual travelers exchanging currency 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. Substantial shifts in international trade patterns can, therefore, impact currency demand and valuation.

However, the rapid and substantial depreciation of the pound since 2016 predates any actual changes in the trade relationship between the UK and the EU. Moreover, trade in goods and services is not the primary driver of overall foreign exchange transactions and typically doesn’t change dramatically in the short term (Bank for International Settlements, BIS, 2019). This suggests that fluctuations in goods and services trade are not the primary cause of extreme exchange rate volatility and may not be the main reason for the Brexit-related pound depreciation.

A critical factor behind the sharp falls in the pound’s value since 2016 is the significant decrease in the inclination of financial institutions to hold investments denominated in pounds. Trading currencies for investment purposes, or trading in financial assets, constitutes the largest portion of currency transactions and is typically the most significant driver of exchange rate changes, especially in the short run.

This is often referred to as ‘hot money’ – highly mobile capital that can swiftly move between investments or currencies on a large scale, causing rapid exchange rate shifts. 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).

Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, leads to a current account deficit. This deficit increases reliance on ‘the kindness of strangers’ and makes the pound more vulnerable to international capital movements. This vulnerability arises because these capital inflows increasingly finance the current account deficit.

Brexit’s Impact on Pound Sterling’s Appeal

Financial institutions operating in currency markets primarily react to factors influencing the returns on investments in different currencies. Consequently, the Brexit-related depreciation of the pound suggests that financial market participants anticipated that investments in pound-denominated assets would perform worse following the Brexit vote than they would have otherwise.

Numerous factors can potentially affect returns in currency markets, and isolating the individual impacts is complex. However, some of the most significant factors are typically shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.

Interest Rate Dynamics

Changes in interest rates, or factors influencing them, are considered a primary driver of exchange rates. This is because domestic interest rates can affect the relative attractiveness of 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 (assuming other factors remain constant) will lead to reduced demand for those assets compared to similar assets in other currencies. This, in turn, causes a depreciation of the currency in question.

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 pound depreciation in June 2016, or in subsequent years, cannot be solely attributed to financial market reactions to this specific interest rate adjustment.

Uncertainty and Political Instability

Changes in risk perception can also influence expected returns and shape investors’ decisions about which assets, including currencies, to hold. Increased uncertainty surrounding factors such as future company performance, economic prospects, interest rates, 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 before 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 likely economic outcomes. The most substantial and sustained pound depreciations since 2016 were closely linked to 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 refused 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 (Bloom et al, 2019).

The Role of Investor Expectations

The pound’s depreciation 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 is because investor expectations are a crucial trigger explaining the timing of 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 affecting expectations about a currency will quickly be reflected in exchange rates. 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-breaking pound depreciation after the referendum exemplifies the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many observers. 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 underscores the negative expectations financial market participants held for pound investments once the outcome was clear.

The substantial pound depreciations in 2017 and 2019 coincided with periods of heightened political uncertainty. These declines also reflect increasingly negative expectations for sterling-denominated investments driven by the growing likelihood 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 Pound Sterling’s Weakness

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 be advantageous. It can enhance export competitiveness by reducing the cost of domestic goods and services for international buyers. This can potentially positively impact the country’s trade deficit and overall economic growth.

Research on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty regarding the extent and implications of post-Brexit trade frictions makes the long-term outcome for the UK economy even more uncertain. Further research is needed to fully understand the long-term consequences of the Brexit-related pound depreciation.