Since the UK’s vote to leave the European Union in June 2016, the currency exchange rate between the pound sterling and the euro has experienced significant fluctuations. By the beginning of 2021, the pound was roughly 15% weaker against the euro compared to its value before the referendum. This represents a 20% decrease from its strength when the EU Referendum Act was enacted in December 2015. Brexit has undeniably become a central factor influencing the volatility of the pound sterling against major global currencies over the past half-decade.
The immediate aftermath of the 2016 referendum witnessed the most dramatic impact, with sterling enduring its most substantial single-day drop in three decades. Further significant 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 was largely driven by growing expectations of increased trade barriers between the UK and the EU, its primary trading partner. Coupled with heightened uncertainty and persistent political instability, these factors prompted financial institutions to sell off pound-denominated assets. This sell-off further weakened the pound’s value relative to other currencies as market confidence waned.
Understanding Exchange Rate Dynamics
An exchange rate represents the price of one currency in relation to 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 shifts in demand. Increased demand for a currency drives its value up, while increased selling pressure pushes it down.
The post-referendum decline in sterling’s value signifies a decrease in the global demand to hold pounds compared to other currencies. To fully grasp the Brexit-related exchange rate shifts, it’s essential to identify the core factors that influence currency demand.
Key Players in Exchange Rate Fluctuations
Participants in the international trade of goods and services play a crucial role in currency markets. This includes multinational corporations engaged in cross-border trade and individual travelers exchanging currencies for personal spending. For instance, when a UK entity purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars in the foreign exchange market. Significant changes in international trade patterns can therefore influence currency demand and valuation.
However, the rapid and substantial depreciation of sterling following 2016 occurred before any tangible changes in the trading relationship between the UK and the EU were implemented. Moreover, the volume of trade in goods and services is not the dominant force in overall foreign exchange transactions and typically doesn’t fluctuate dramatically in the short term (according to the Bank for International Settlements, BIS, 2019). This suggests that trade in goods and services may not be the primary driver behind extreme exchange rate volatility and might not be the main reason for the Brexit-related decline in sterling’s value.
A more critical factor behind the sharp falls in the pound since 2016 is the significant reduction in the inclination of financial institutions to hold investments denominated in pounds. Trading currencies for investment purposes, or trading in financial assets, constitutes the majority of currency transactions and is generally the most significant driver of exchange rate changes, particularly in the short run.
This type of capital flow 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 adjustments. 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. Direct transactions from non-financial customers represented only 4.9% of the total currency exchange volume (BIS, 2019).
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, leads to a reliance on external financing, making the pound more susceptible to international capital movements. This current account deficit is increasingly funded by these capital inflows, amplifying the pound’s vulnerability.
Brexit’s Impact on the Pound’s Appeal
Financial institutions operating in currency markets primarily respond to factors that affect the profitability of investments in different currencies. The Brexit-related decline in sterling’s value indicates that financial market participants anticipated that investments in pound-denominated assets would perform less favorably post-Brexit than they would have otherwise.
Numerous factors can influence returns in currency markets, making it challenging to isolate individual effects. However, key factors typically include changes in relative interest rates, shifts in risk perception, and evolving investor expectations.
Interest Rate Dynamics
Changes in interest rates, or factors influencing them, are widely recognized as significant drivers of exchange rates. Domestic interest rates can impact the relative returns 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 (assuming other factors remain constant) will lead to decreased demand for those assets compared to assets in currencies offering higher returns. This, in turn, causes a depreciation in the value of the currency.
For instance, 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 adjustment was announced weeks after the Brexit vote. Therefore, the immediate and sharp decline 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 change.
Uncertainty and Political Instability
Changes in perceived risk also significantly affect expected returns and shape investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors such as future company performance, economic forecasts, interest rate trajectories, and political stability can elevate the risk associated with holding assets in a specific currency. This increased risk can discourage or delay investment inflows.
The heightened probability of increased trade frictions between the UK and the EU after Brexit amplified these risks for assets denominated in pounds. Pre-referendum research anticipated 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 surrounding post-Brexit trade relationships and the anticipated economic outcomes. 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, following an early general election that resulted in a hung parliament. In 2019, the pound plummeted to a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister, fueled by his refusal to rule out a no-deal Brexit – widely considered the most damaging economic scenario for the UK.
Evidence suggests that the negative consequences of this uncertainty on employment, productivity, and investment within UK businesses became increasingly apparent in the years immediately following the referendum.
The Role of Expectations
The depreciation of sterling began before Brexit officially 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 timing highlights the crucial role of investor expectations in driving currency movements.
Changes in investor expectations are rapidly incorporated into currency markets due to the immense volume and speed of trading. Any new information influencing currency expectations is quickly reflected in exchange rates. If market participants anticipate negative future impacts on investments in a particular currency, they will sell that currency, causing its value to fall.
The record-breaking fall of the pound after the referendum demonstrates the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many analysts. Last-minute polls suggested a likely Remain victory, initially causing sterling to appreciate in the days leading up to the referendum. The pound’s collapse immediately after the result underscored the negative expectations that financial market participants held for sterling 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 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 established specific links between economic policy uncertainty and exchange rate expectations. Findings indicate that market participants factor in the level of policy uncertainty when forming their expectations about currency values.
Consequences of Sterling’s Depreciation
A direct consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK consumers and businesses. This leads to increased inflation and a higher cost of living.
However, a weaker currency can also offer benefits. It can enhance export competitiveness by reducing the cost of domestic goods and services for international buyers. This 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 scope and implications of post-Brexit trade frictions makes the long-term economic outlook for the UK even more uncertain. Further research is necessary to fully understand the long-term consequences of the Brexit-related fall in sterling.
Further Resources
For those seeking deeper insights into this topic, the following experts are recognized in the field:
- 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 (Queen’s University Belfast)
