At the beginning of 2021, the British pound (GBP) was approximately 15% weaker against the euro (EUR) compared to its position before the 2016 Brexit referendum. This represented a significant shift from June 2016, and even more dramatically, a 20% decrease from December 2015 when the EU Referendum Act was enacted. The depreciation of the pound against the euro has been a notable economic consequence of Brexit, reflecting broader market reactions and shifts in investor sentiment.
Brexit has undeniably been a central factor influencing the volatility of exchange rates and the value of the pound sterling against major global currencies over the past half-decade. The immediate aftermath of the referendum vote vividly illustrated this impact, with sterling experiencing its most substantial single-day decline in 30 years. Further significant and sustained drops occurred in 2017 and 2019, pushing the pound to new lows against both the euro and the US dollar by August 2019, as depicted in Figure 1.
This depreciation was largely driven by market anticipation of increased trade barriers between the UK and its largest trading partner, the European Union. Coupled with heightened uncertainty and persistent political instability surrounding Brexit negotiations, financial institutions reacted by selling off pound-denominated assets. This widespread selling pressure further diminished the pound’s value relative to other currencies, particularly the euro.
Figure 1: Daily Euro to Pound Sterling Exchange Rate Fluctuations from 2015 to 2021, highlighting the impact of Brexit events on currency values.
Understanding Exchange Rate Dynamics: Supply and Demand
An exchange rate is fundamentally the price of one currency expressed in terms of another. Like any price in a market economy, it fluctuates based on the principles of supply and demand. In the context of currency exchange, when demand for a specific currency rises, its value appreciates relative to other currencies. Conversely, when demand falls, the currency depreciates.
The post-referendum decline in the value of the pound sterling signifies a decrease in the global demand to hold pounds compared to other currencies, particularly the euro. To fully grasp the underlying reasons for Brexit-related exchange rate movements, it’s essential to identify the key factors that influence the demand for a currency.
Key Players in Currency Markets: Beyond Trade
Participants in international trade, dealing with goods and services, are significant actors in currency markets. This includes multinational corporations engaged in cross-border sales and individual travelers exchanging currency for personal expenses. For instance, when a UK business imports goods from the Eurozone, they need to convert pounds into euros, thereby increasing the demand for euros and potentially influencing the Euro To Pound Sterling exchange rate. Significant shifts in international trade volumes can indeed impact currency demand and valuation over time.
However, the rapid and substantial falls in the pound’s value following the 2016 referendum occurred before any tangible changes in the UK-EU trading relationship had materialized. Moreover, trade in goods and services isn’t the primary driver of overall foreign exchange transactions, and these transactions don’t typically exhibit sharp short-term fluctuations (according to the Bank for International Settlements, BIS, 2019). This suggests that factors beyond trade in goods and services were the main catalysts for the dramatic exchange rate volatility and the pound’s depreciation associated with Brexit.
A critical factor behind the sharp decline in the pound’s value post-2016 is the significant reduction in the inclination of financial institutions to hold investments denominated in pounds. Currency trading for investment purposes, or trading in financial assets, constitutes the largest segment of currency transactions and is generally the most influential driver of exchange rate movements, especially in the short term.
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 shifts in exchange rates. Consequently, the dominant and 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 attributable to non-financial customers (BIS, 2019).
Adding to the pound’s vulnerability, the UK consistently imports more than it exports, resulting in a current account deficit. This deficit increases the UK’s reliance on international capital inflows and makes the pound more susceptible to the ebb and flow of global capital movements. The current account deficit has been increasingly financed by these capital inflows, amplifying this vulnerability.
Brexit’s Impact on the Pound: Uncertainty and Investor Confidence
The primary factors that financial institutions consider in currency markets are those that affect the profitability of investments in different currencies. Therefore, the Brexit-related depreciation of the pound indicates 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 influence returns in currency markets, and isolating the impact of each factor is complex. Nevertheless, some of the most significant factors are typically shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.
Interest Rates
Changes in interest rates, or factors impacting interest rates, are widely recognized as key drivers of exchange rates. Domestic interest rates can influence the relative returns on assets in different countries. A decrease in a country’s interest rates implies that assets linked to that rate will yield lower returns. An unexpected interest rate cut (assuming other factors remain constant) will lead to reduced demand for those assets compared to equivalent assets in currencies offering higher returns. This, in turn, will cause 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 adjustment was announced weeks after the Brexit referendum. Therefore, the immediate and substantial fall in the pound’s value in June 2016, and 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 influence investor decisions regarding asset and currency holdings. Increased uncertainty surrounding factors like future business 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 lead to reduced or delayed investment inflows (Pindyck, 1991).
The high probability of increased trade frictions 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 further compounded by significant and persistent political instability in the UK, which prolonged and deepened uncertainty surrounding post-Brexit trade relationships and the anticipated economic outcomes. The most substantial and sustained declines in the pound since 2016 were closely correlated with heightened uncertainty and related political turmoil.
A particularly sharp fall in the pound’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 and did not rule out a ‘no-deal’ Brexit – widely considered the most adverse potential economic scenario for the UK.
Evidence suggests that the negative repercussions 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 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 play a crucial role in triggering currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly integrated into currency markets due to the sheer volume and speed of trading. Any new information that influences 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 in a particular currency, they will sell that currency, causing its value to decline.
The record fall in the pound immediately after the referendum underscores the rapid impact of shifting market expectations on currencies. The Leave vote surprised many, as 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 announcement highlights the negative expectations that financial market participants developed for pound sterling investments once the outcome became clear.
The significant pound depreciations in 2017 and 2019 occurred during periods of heightened political uncertainty. These declines also reflect increasingly pessimistic expectations for pound-denominated investments, driven by the growing likelihood of a ‘hard’ Brexit. Conversely, improved optimism regarding 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 exchange rate expectations.
Consequences of a Weaker Pound Sterling
One immediate consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK consumers and businesses. This contributes to higher inflation rates and an increased 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 stimulate overall economic growth.
Research on the net effect of currency depreciation is mixed and inconclusive. Furthermore, ongoing uncertainty surrounding the magnitude and implications of post-Brexit trade frictions makes predicting the long-term consequences for the UK economy even more challenging. Further research is necessary to fully understand the long-term effects of the Brexit-related fall in the pound sterling against the euro and other currencies.
Further Reading and Expert Insights
For those seeking deeper insights, further resources and expert perspectives are available from:
Experts on Exchange Rates and Brexit Impact:
- 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)
