Since the UK voted to leave the European Union in June 2016, the relationship between the English Pound and the Euro has been under significant pressure. At the beginning of 2021, the pound was approximately 15% weaker against the euro compared to its position before the 2016 referendum. This devaluation is even more stark when considering the period before the referendum campaign gained momentum; the pound was 20% weaker than when the EU Referendum Act received Royal Assent in December 2015.
Brexit has undeniably emerged as a dominant force influencing the volatility of exchange rates and the overall value of the pound sterling against major global currencies over the past half-decade. The immediate aftermath of the referendum delivered a sharp shock to the currency markets, with sterling experiencing its most dramatic single-day drop in 30 years. This initial plunge was followed by further substantial and sustained declines in 2017 and 2019, culminating in the pound reaching new lows against both the euro and the US dollar in August 2019, as illustrated in Figure 1.
This depreciation was largely fueled by growing expectations of increased trade barriers between the UK and the EU, its largest trading partner. Coupled with heightened uncertainty surrounding the future economic and political landscape of the UK, financial institutions began selling off pound-denominated assets. This sell-off, driven by concerns over future economic performance and stability, further accelerated the pound’s decline relative to other currencies, particularly the euro.
Understanding Exchange Rate Dynamics
An exchange rate, at its core, is simply the price of one currency expressed in terms of another. Like any price in a market economy, it fluctuates based on the fundamental principles of supply and demand. In the context of currency exchange, when demand for one currency within a pair increases relative to the other, its value will appreciate, while the value of the other currency will depreciate.
The post-referendum decline in the value of sterling fundamentally reflects a decrease in the global demand to hold pounds relative to other currencies, most notably the euro. To fully grasp the underlying reasons for Brexit-related exchange rate movements, it’s crucial to identify the key factors that influence the demand for a particular currency.
Key Players in Currency Exchange Markets
Participants in the international trade of goods and services are significant actors in currency markets. This includes multinational corporations engaged in cross-border trade, as well as individual travelers exchanging currency for tourism or personal use. For instance, when a UK business imports goods from a Eurozone country, they must convert pounds into euros to complete the transaction, thereby increasing the demand for euros and potentially affecting the English Pound Euro Exchange Rate. Significant shifts in international trade patterns can therefore influence the demand for and value of a currency.
However, the rapid and substantial falls in the value of sterling after 2016 predated any actual changes in the trading relationship between the UK and the EU. Moreover, while trade in goods and services is important, it is not the primary driver of overall foreign exchange transactions, and it tends to change relatively slowly in the short term (Bank for International Settlements, BIS, 2019). This suggests that changes in international trade alone are insufficient to explain the extreme volatility in exchange rates and were likely not the main cause of the Brexit-related depreciation of the pound.
The primary driver behind the sharp declines in the pound’s value since 2016 is the substantial reduction in the preference 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 fluctuations, particularly in the short run.
This type of capital movement is often referred to as ‘hot money’ – funds that are highly mobile and can be quickly shifted between investments or currencies on a large scale, leading to rapid impacts on exchange rates. Consequently, the most influential participants in currency markets are financial institutions such as banks, investment 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 current account deficit, where imports consistently exceed exports, increases its reliance on international capital flows and makes the pound more susceptible to the movements of global capital. This vulnerability arises because the current account deficit has been increasingly financed by these capital inflows, making the currency sensitive to investor sentiment.
Brexit’s Impact on Pound Sterling’s Attractiveness
Financial institutions, when operating in currency markets, primarily respond to factors that influence the expected return on investments in different currencies. Therefore, the depreciation of sterling associated with Brexit indicates that financial market participants anticipated that investments in pound-denominated assets would perform less favorably following the vote to leave the EU than they would have otherwise.
Numerous factors can potentially affect returns in currency markets, and isolating the specific impact of each is complex. However, some of the most influential factors typically include changes in relative interest rates, shifts in perceived risk, and changes in the overall expectations of investors.
Interest Rates
Changes in interest rates, or factors influencing interest rates, are widely recognized as primary drivers of exchange rates. This is because domestic interest rates can significantly affect the relative attractiveness of assets in different countries. A decrease in interest rates in a particular country reduces the returns on assets linked to that rate. An unexpected cut in interest rates, all else being equal, leads to a decrease in demand for those assets relative to similar assets in currencies offering higher returns. 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 program of ‘quantitative easing’ (QE). However, it’s important to note that this policy change was implemented weeks after the initial Brexit vote. Therefore, the immediate and sharp fall in the pound’s value in June 2016, and subsequent declines in later years, cannot be solely attributed to the financial market’s reaction to this specific interest rate cut.
Uncertainty and Political Instability
Changes in perceived risk also play a crucial role in shaping expected returns and influencing investor decisions regarding which assets, including currencies, to hold. Increased uncertainty surrounding factors such as future business performance, the overall economic outlook, interest rate trajectories, and political stability can make holding assets in a specific 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 assets denominated in pounds. Research conducted before the referendum predicted substantial decreases in foreign investment in the UK as a consequence of Brexit-related trade costs (Dhingra et al, 2016).
These economic risks were further compounded by significant and persistent political instability in the UK, which prolonged and deepened the uncertainty surrounding post-Brexit trading arrangements and the anticipated economic consequences. The most pronounced and sustained declines in the pound since 2016 were closely correlated with periods of heightened uncertainty and associated political turmoil.
A notable example is the sharp fall in sterling’s value against the euro in 2017, which followed an early general election resulting in a hung parliament. Similarly, 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 and indicated a willingness to consider a ‘no-deal’ Brexit – widely considered the most damaging 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 the pound largely occurred before Brexit actually materialized. 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 that helps explain the timing of currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly incorporated into currency markets due to the immense volume and speed of trading. Any new information that alters expectations about a currency’s future prospects will quickly be reflected in its exchange rate. If market participants anticipate a negative future impact on investments denominated in a particular currency, they will sell that currency, causing its value to fall.
The record-breaking fall of the pound after the referendum vividly illustrates the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many analysts. Pre-referendum polls had suggested a likely Remain victory, initially leading to a slight appreciation of sterling in the days leading up to the vote. The subsequent collapse in the pound’s value immediately after the result underscores the negative expectations that financial market participants developed regarding sterling investments once the outcome became clear.
The significant falls in the pound in 2017 and 2019, during periods of heightened political uncertainty, further reflect increasingly pessimistic expectations for sterling-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, improved optimism regarding an orderly Brexit and a potential trade deal 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 suggest that market participants actively consider the level of policy uncertainty when forming their expectations about future currency values.
Consequences of a Weaker Pound
One immediate consequence of a weaker pound is that goods, services, and assets originating from foreign countries become more expensive for UK residents. This directly translates to higher levels of inflation and an increased cost of living.
However, a weaker currency can also offer potential benefits. It can enhance the competitiveness of exports by making domestically produced goods and services cheaper for buyers in other countries. This can potentially lead to positive effects on a country’s trade deficit and overall economic growth.
Research examining the net effect of currency depreciation is, at best, inconclusive. Furthermore, the ongoing uncertainty surrounding the extent and implications of post-Brexit trade frictions makes the long-term economic outcome for the UK even more ambiguous. Further in-depth research is necessary to fully understand the long-term consequences of the Brexit-related fall in the english pound euro exchange rate.
Further Resources and Expert Insights
For those seeking deeper knowledge on this topic, the following resources and experts offer valuable insights:
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)
Author: Christopher Coyle
