At the beginning of 2021, the British pound was significantly weaker against the euro, approximately 15% lower than it was before the 2016 Brexit referendum. This depreciation is even more stark when compared to December 2015, when the EU Referendum Act was enacted, showing a 20% decrease.
Over the past half-decade, Brexit has emerged as a dominant factor influencing the volatility of exchange rates and the pound’s value against major global currencies. The immediate aftermath of the referendum vote vividly illustrated this impact, as sterling plummeted, marking 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 shown in Figure 1.
This devaluation was largely driven by growing expectations of increased trade barriers between the UK and the European Union, its largest trading partner. Coupled with heightened uncertainty and persistent political instability, these factors prompted financial institutions to sell off pound-denominated assets. This selling pressure further eroded the pound’s value relative to other currencies.
The Dynamics of Exchange Rate Fluctuations
An exchange rate represents the price of one currency in relation to another. Its fluctuations are governed by the fundamental principles of supply and demand. In any currency pair, when demand for one currency increases and supply of the other rises, the former’s value appreciates while the latter depreciates.
The post-referendum decline in sterling’s value essentially reflects a decrease in the demand for holding pounds compared to other currencies. To fully grasp the underlying reasons for Brexit-related exchange rate shifts, it’s crucial to identify the factors that influence currency demand.
Key Players in Exchange Rate Movements
Businesses engaged in international trade of goods and services are significant and regular participants in currency markets. This includes companies involved in cross-border sales and individual travelers exchanging currency for personal use. For instance, when a UK entity purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars. Substantial shifts in international trade flows can thus impact currency demand and valuation.
However, the rapid and substantial falls in the pound’s value since 2016 preceded any actual alterations 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 are not the primary cause of extreme exchange rate fluctuations and may not be the main reason for the Brexit-related pound devaluation.
A critical factor behind the sharp declines in the pound’s value since 2016 is a significant reduction in the inclination of financial institutions to hold pound-denominated investments. Currency trading for investment purposes, or trading in financial assets, constitutes the largest share of currency transactions and is usually the most significant driver of exchange rate changes, particularly in the short term.
This is often termed ‘hot money’ – highly mobile capital that can swiftly move between investments or currencies on a large scale, rapidly impacting exchange rates. Consequently, the most influential players in currency markets are financial institutions like 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. Direct currency exchange volume from non-financial customers was a mere 4.9% (BIS, 2019).
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, increases reliance on external financing and makes the pound more vulnerable to international capital flows. This vulnerability arises because the current account deficit has been increasingly funded by these capital inflows.
Brexit’s Impact on the Pound’s Appeal
Financial institutions in currency markets primarily react to factors that influence the returns on investments in different currencies. Therefore, the Brexit-related pound devaluation indicates that financial market participants anticipated poorer performance for pound-denominated investments post-Brexit.
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, risk perception, and overall investor expectations.
Interest Rates
Changes in interest rates, or factors influencing them, are considered primary drivers of exchange rates. Domestic interest rates can affect 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 interest rate cut (holding other factors constant) leads to decreased demand for those assets relative to similar assets in other currencies, causing the currency’s value to fall.
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, this policy change occurred weeks after the Brexit vote. Therefore, the significant pound devaluation in June 2016, or in subsequent years, cannot be solely attributed to the financial market reaction to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in perceived risk also impact expected returns and influence investor decisions on asset holdings, including currencies. Increased uncertainty surrounding factors like future business performance, economic outlook, interest rates, and political stability can elevate the risk of holding assets in a specific currency. This heightened risk can reduce or postpone investment inflows (Pindyck, 1991).
The high probability of increased trade friction 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 compounded by significant and persistent political instability in the UK, prolonging and deepening uncertainty regarding post-Brexit trade relations and the likely economic consequences. The most substantial and sustained pound depreciations since 2016 coincided with periods of heightened uncertainty and associated political turmoil.
A notable pound devaluation against the euro occurred in 2017 after an early general election 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 regarded as 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).
Expectations
The pound’s devaluation began before Brexit actually materialized. Conversely, exchange rate movements were relatively muted when the UK officially left the EU and the transition period ended in late 2020. This is because investor expectations are a crucial catalyst in currency movements (Dornbusch, 1976; Engle and West, 2005).
Shifting investor expectations are rapidly integrated into currency markets due to the sheer volume and speed of trading. New information impacting currency expectations is quickly reflected in exchange rates. If market participants anticipate negative future impacts on investments in a currency, they will sell that currency, causing its value to decline.
The record pound devaluation after the referendum highlights the swift impact of changing market expectations on currencies, as the Leave vote surprised many observers. Last-minute polls suggested a Remain victory, initially causing the pound to appreciate in the days leading up to the referendum. The pound’s collapse immediately following the result underscores the negative expectations financial market participants held for pound investments once the outcome became clear.
The significant pound declines in 2017 and 2019 during periods of heightened political uncertainty also reflect increasingly negative expectations for pound-denominated investments due to the rising probability of a ‘hard’ Brexit. Conversely, improved prospects for an orderly Brexit and a trade agreement preceded increases in the pound’s value.
Recent research has established 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 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 be beneficial 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 on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the extent and implications of post-Brexit trade frictions makes the long-term outcome for the UK economy even more ambiguous. Further research is necessary to fully understand the long-term consequences of the Brexit-related pound devaluation.
Further Resources
Experts on Exchange Rates and Brexit
- 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
