Since the Brexit referendum in June 2016, the exchange rate of pound sterling (GBP) to euro (EUR) has experienced significant volatility. At the beginning of 2021, the pound was approximately 15% weaker against the euro compared to its value before the referendum. This represents a substantial shift in the economic landscape between the UK and the Eurozone. Furthermore, sterling’s value was even lower, about 20% weaker, than when the EU Referendum Act was enacted in December 2015.
The last five years have demonstrated Brexit’s profound influence on currency exchange rates, particularly the pound’s value against major global currencies. The immediate aftermath of the referendum vote saw the most dramatic effect, with sterling suffering its largest single-day drop in three decades. Further significant and sustained declines occurred in 2017 and 2019, culminating in new lows for the pound against both the euro and the US dollar in August 2019, as illustrated in Figure 1.
This depreciation was largely driven by market anticipations of increased trade barriers between the UK and the European Union, its largest trading partner. Coupled with rising uncertainty and persistent political instability, these factors prompted financial institutions to sell off pound-denominated assets. This sell-off intensified, further weakening the pound’s value relative to other currencies like the euro.
The Mechanics of Exchange Rate Changes: Supply and Demand
An exchange rate represents the price of one currency in terms of another. Like any price in a market economy, it is governed by the principles of supply and demand. When demand for a currency increases, its value appreciates relative to the other currency in the pair, and vice versa. Conversely, increased supply leads to depreciation.
The post-referendum decline in the pound’s value signifies a reduced demand for holding sterling compared to other currencies, including the euro. To fully grasp the Brexit-related exchange rate movements, it’s crucial to understand the factors that influence the demand for a currency in the foreign exchange market.
Key Players in Currency Markets: Who Drives Exchange Rate Fluctuations?
Businesses engaged in international trade are significant participants in foreign exchange markets. This includes exporters and importers, as well as individuals traveling abroad who exchange currency for personal spending. For instance, when a UK company imports goods from the Eurozone, it needs to convert pounds into euros, thereby increasing the demand for euros and potentially affecting the GBP/EUR exchange rate. Large shifts in international trade flows can therefore influence currency demand and valuation.
However, the sharp and rapid falls in the pound’s value after 2016 preceded any actual changes in the trade relationship between the UK and the EU. Moreover, trade in goods and services isn’t the dominant force in overall foreign exchange transactions, and it doesn’t typically change dramatically in the short term (Bank for International Settlements, BIS, 2019). This suggests that factors beyond trade in goods and services were the primary drivers of the extreme exchange rate volatility and the pound’s depreciation linked to Brexit.
A critical factor behind the pound’s sharp depreciation since 2016 is the significant decrease in the attractiveness of pound-denominated investments to financial institutions. Trading currencies 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, especially in the short run.
This is often referred to as “hot money” – capital that is highly mobile and can swiftly move between investments or currencies on a large scale, causing rapid exchange rate fluctuations. Consequently, the most influential players 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).
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, results in a current account deficit. This deficit increases the UK’s reliance on international capital flows and makes the pound more susceptible to movements of global capital, as these inflows increasingly fund the current account deficit.
Brexit’s Impact on Pound Sterling’s Appeal: Factors Influencing Investor Sentiment
Financial institutions operating in currency markets primarily respond to factors that impact the returns on investments in different currencies. The post-Brexit decline in the pound’s value indicates that financial market participants believed that investments in pound-denominated assets would perform less favorably after the Brexit vote than they would have otherwise.
Several factors can influence returns in currency markets, and isolating the impact of each is complex. However, some of the most significant factors typically include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations.
Interest Rate Dynamics and the GBP/EUR Exchange Rate
Changes in interest rates, or factors influencing them, are widely recognized as a primary driver of exchange rates. This is because domestic interest rates can affect the relative attractiveness of 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) typically leads to reduced demand for those assets compared to similar assets in other currencies, causing a depreciation of the currency in question.
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 program of “quantitative easing” (QE). However, it’s important to note that this policy change was announced weeks after the Brexit referendum. Therefore, the significant drop in the pound’s value in June 2016, or in subsequent years, cannot be solely attributed to the immediate reaction of financial markets to this specific interest rate policy change.
Uncertainty and Political Instability: Risk Premiums and Currency Valuation
Changes in perceived risk also play a significant role in expected returns and influence investors’ decisions about which assets, including currencies, to hold. Increased uncertainty surrounding factors such as future business performance, economic prospects, interest rate paths, and political stability can make holding assets in a particular currency riskier. This heightened risk perception can reduce or delay investment inflows (Pindyck, 1991).
The increased likelihood of greater trade frictions between the UK and the EU following Brexit amplified these risks for pound-denominated assets. Research conducted before 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. This 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.
A notable example is one of the largest falls in sterling against the euro in 2017, which followed an early general election resulting in a hung parliament. In 2019, the pound reached a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister. His refusal to rule out a “no-deal” Brexit scenario, widely considered the worst possible economic outcome for the UK, further weakened investor confidence.
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 Investor Expectations in Exchange Rate Movements
Interestingly, the pound’s depreciation largely occurred before Brexit actually took place. In contrast, exchange rate movements were relatively muted when the UK formally left the EU and the transition period ended at the close of 2020. This highlights the crucial role of investor expectations in triggering 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 influences expectations about a currency’s future prospects will quickly be 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 fall.
The record fall in the pound immediately after the referendum exemplifies the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many analysts. Pre-referendum polls suggested a likely Remain victory, initially causing sterling to appreciate 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 for sterling investments once the outcome became clear.
The significant falls in the pound 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 demonstrated 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 about currency values.
Consequences of a Weaker Pound Sterling: Impact on the UK Economy
One immediate consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK residents and businesses. This directly contributes to higher inflation and an increased cost of living.
However, a weaker currency can also offer potential benefits. It can enhance export competitiveness by reducing the cost of domestic goods and services for buyers in other countries, like the Eurozone. This could potentially improve the UK’s trade deficit and contribute to 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 economic outcome for the UK even more uncertain. Further research is necessary to fully understand the long-term consequences of the Brexit-related fall in the pound sterling to euro exchange rate.
Further Reading and Expert Insights
For deeper insights into this topic, consider exploring resources from the experts listed below:
Experts on Exchange Rates and International Finance:
- 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)
