The journey of the pound sterling against the euro since the 2016 Brexit referendum has been marked by significant volatility. At the beginning of 2021, the pound was approximately 15% weaker against the euro compared to its position before the referendum vote on the UK’s EU membership in June 2016. Looking further back, sterling’s value was even more pronounced, sitting 20% lower than when the EU Referendum Act was enacted in December 2015.
Over the past half-decade, Brexit has emerged as a dominant factor influencing exchange rate fluctuations and the overall strength of the pound relative to major global currencies. The immediate aftermath of the referendum vividly illustrated this impact, as sterling experienced its most dramatic 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 dollar by August 2019, as depicted in Figure 1.
This depreciation was largely attributed to 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. As the volume of sterling assets sold increased, the value of the pound inevitably decreased in comparison to other currencies.
The Dynamics of Exchange Rate Fluctuations: Supply and Demand
An exchange rate essentially represents the price of one currency in terms of another. These rates are governed by the fundamental principles of supply and demand. In any currency pair, one currency will appreciate (increase in value) while the other depreciates (decrease in value) based on buying and selling pressures. Increased demand for a currency drives its value up, while increased supply pushes it down.
The decline in the pound’s value since the referendum indicates a reduced demand for holding pounds compared to other currencies. To understand the fundamental drivers behind these Brexit-related exchange rate movements, it’s crucial to examine the factors that influence the demand for a currency.
Key Players in Currency Exchange Markets
Organizations engaged in international trade of goods and services are significant participants in currency markets. This includes multinational corporations involved in cross-border transactions and individual travelers exchanging currency for personal expenses. For instance, when a UK business or resident purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars in the foreign exchange market. Significant shifts in international trade patterns can therefore impact the demand for and value of a currency.
However, the rapid and significant depreciation of sterling following 2016 occurred before 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 total foreign exchange transactions and tends to be relatively stable in the short term (Bank for International Settlements, BIS, 2019). This suggests that fluctuations in goods and services trade are not the main cause of extreme exchange rate volatility and may not fully explain the Brexit-related fall in the pound’s value.
A critical factor contributing to the sharp declines in the pound since 2016 is a substantial 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 segment of currency transactions and is typically the most influential driver of exchange rate changes, particularly in the short run.
This type of capital is often referred to as ‘hot money’ – highly mobile funds that can rapidly shift between investments or currencies, causing swift and significant impacts 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. 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 exceed exports, increases its reliance on ‘the kindness of strangers’ and makes the pound more vulnerable to international capital flows. This vulnerability stems from the fact that the current account deficit has been increasingly financed by these very capital inflows.
Brexit’s Impact on Pound Sterling’s Appeal
The primary factors that drive financial institutions’ decisions in currency markets are those that influence the expected returns on investments in different currencies. Therefore, the Brexit-related depreciation of sterling suggests that financial market participants anticipated that investments in pound-denominated assets would perform less favorably after the Brexit vote than they would have otherwise.
Numerous factors can potentially affect returns in currency markets, making it challenging to isolate the individual effects. However, some of the most significant factors typically include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations.
Interest Rates and Currency Conversion
Changes in interest rates, or factors influencing them, are considered major drivers of exchange rates. This is because domestic interest rates can alter the relative attractiveness of assets in different countries. A reduction in a country’s interest rates diminishes 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 equivalent assets in other currencies. This, in turn, causes a depreciation in the value 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 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.
Uncertainty, Political Instability, and Exchange Rates
Changes in risk perception can also significantly impact expected returns and influence investors’ decisions regarding which assets, including currencies, to hold. Increased uncertainty surrounding factors such as future company performance, economic outlook, interest rates, and political stability can make holding assets in a particular currency riskier, leading to reduced or delayed investment flows (Pindyck, 1991).
The increased likelihood of 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 deepened the uncertainty surrounding post-Brexit trade relationships and the likely economic consequences. The most substantial and sustained declines in the pound’s value since 2016 were closely correlated with periods of heightened uncertainty and associated political turmoil.
One of the most significant drops in sterling’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 Expectations in Currency Markets
The depreciation of sterling occurred predominantly before Brexit actually took place. In contrast, 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 crucial 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 vast volume and speed of trading. Any new information that impacts expectations about a currency is swiftly 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 decline.
The record fall of the pound after the referendum exemplifies the rapid effect of shifting market expectations on currencies, as the Leave vote surprised many analysts. Last-minute polls suggested a likely Remain victory, which initially caused sterling to appreciate in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately after the result underscored the negative expectations that financial market participants held for sterling investments once the outcome became clear.
The significant drops in the pound in 2017 and 2019 coincided with periods of heightened political uncertainty. These declines also reflected increasingly pessimistic expectations for sterling-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, improved hopes for 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 suggest that market participants factor in the level of policy uncertainty when forming their expectations, which in turn impacts currency conversion rates.
Consequences of a Weaker Pound Sterling
One immediate consequence of a weaker pound is that goods, services, and assets from abroad become more expensive for UK residents. This leads to increased inflation and a higher cost of living. For individuals looking at Conversion Pound Euro for travel or business, this means their pounds will buy fewer euros than before the depreciation.
However, a weaker currency can also offer benefits. It can make exports more competitive by reducing the cost of domestic goods and services for international buyers. This can potentially improve a country’s trade deficit and stimulate 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 necessary to fully understand the long-term consequences of the Brexit-related fall in sterling and its impact on conversion pound euro rates and the broader economy.
Further Reading and Expert Insights
For deeper insights into this topic, consider exploring resources from the following experts:
Experts on Exchange Rates and Currency Markets
- 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)
