Since the beginning of 2021, the value of the pound sterling has noticeably decreased against the euro, sitting approximately 15% lower than it was in June 2016, before the UK referendum on European Union membership. This devaluation is even more stark when compared to December 2015, when the EU Referendum Act received Royal Assent, marking a 20% drop for sterling.
The period spanning the last five years has seen Brexit emerge as a dominant force influencing the volatility of exchange rates, particularly the pound’s value relative to major global currencies. The immediate aftermath of the 2016 referendum vote vividly illustrated this impact, with sterling experiencing its most significant 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 US dollar by August 2019, as depicted in Figure 1.
This devaluation primarily stemmed from growing expectations of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and ongoing political instability. These factors prompted financial institutions to sell off pound-denominated assets. As this selling trend gained momentum, the pound’s value was driven down in comparison to other currencies, impacting the pound sterling to euro exchange rate significantly.
Figure 1: GBP/EUR Exchange Rate Daily Movements (2015-2021)
Source: Bloomberg
The Dynamics of Exchange Rate Shifts
An exchange rate represents the price of one currency in terms of another. Its fluctuations 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 – an increase in demand for one currency and a decrease for the other drives this change.
In essence, the post-referendum decline in the pound sterling to euro exchange rate reflects a reduced demand to hold pounds compared to other currencies. To fully grasp the underlying reasons for these Brexit-related exchange rate movements, it’s crucial to identify the key factors that influence the demand for a currency.
Key Players in Exchange Rate Fluctuations
Organizations engaged in international trade are significant participants in currency markets. This includes businesses involved in cross-border sales of goods and services, as well as individual travelers exchanging currency for personal expenses. For instance, when a UK entity purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars. Substantial shifts in international trade can, therefore, alter the demand for and value of a currency, affecting exchange rates like the pound sterling to euro.
However, the rapid and significant drops in the pound’s value since 2016 preceded any actual changes in the trading relationship between the UK and the EU. Moreover, trade in goods and services isn’t the primary driver of overall foreign exchange transactions and typically doesn’t change dramatically in the short term (Bank for International Settlements, BIS, 2019). This suggests that fluctuations in the trade of goods and services may not be the main cause of extreme exchange rate volatility, and possibly not the primary reason for the Brexit-induced fall in the pound sterling to euro exchange rate.
A critical factor contributing to the sharp declines in the pound’s value since 2016 is the substantial decrease in financial institutions’ preference to hold pound-denominated investments. Currency trading for investment purposes, or trading in financial assets, constitutes the majority of currency transactions and is usually the most significant driver of exchange rate changes, particularly 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, rapidly impacting exchange rates. Consequently, the most influential participants in currency markets are financial institutions such as banks, securities firms, and institutional investors who heavily influence the pound sterling to euro exchange rate.
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 international capital inflows and makes the pound more susceptible to global capital movements. This vulnerability arises because the current account deficit has been increasingly funded by these capital inflows, making the pound sterling to euro exchange rate more sensitive to investor sentiment.
Brexit’s Impact on the Pound’s Appeal
The primary factors that financial institutions consider in currency markets are those affecting the returns on investments in different currencies. The Brexit-related fall in the pound sterling to euro exchange rate indicates that financial market participants anticipated poorer performance for pound-denominated investments post-Brexit.
Several factors can influence returns in currency markets, and isolating the individual effects is complex. However, some of the most crucial factors typically include changes in relative interest rates, shifts in risk perception, and evolving investor expectations, all playing a role in the pound sterling to euro valuation.
Interest Rates
Changes in interest rates, or factors influencing them, are considered a primary driver of exchange rates. Domestic interest rates can impact the relative return on assets across different countries. Lower interest rates in a country reduce the returns on assets linked to that rate. An unexpected decrease in interest rates, assuming other factors remain constant, leads to reduced demand for those assets compared to assets in other currencies. This, in turn, causes a depreciation in the value of the currency, directly affecting the pound sterling to euro exchange rate.
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 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 the immediate reaction of financial markets to this specific interest rate event.
Uncertainty and Political Instability
Changes in risk assessment can also affect expected returns and influence investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors like future company performance, economic outlook, interest rates, and political stability can make holding assets in a particular currency riskier. This heightened risk can reduce or delay investment inflows (Pindyck, 1991), impacting the pound sterling to euro exchange rate.
The heightened likelihood of increased trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Pre-referendum research anticipated substantial declines in foreign investment in the UK due to Brexit-related trade costs (Dhingra et al, 2016).
These risks were compounded by significant and persistent political instability in the UK, prolonging and deepening the uncertainty surrounding post-Brexit trading relationships and the anticipated economic consequences. The most substantial and sustained falls in the pound since 2016 were closely linked to increased uncertainty and associated political turbulence, directly impacting the pound sterling to euro exchange rate.
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 fell to a new multi-year low against both the dollar and the euro shortly after Boris Johnson became Prime Minister. His refusal to dismiss the possibility of a ‘no-deal’ Brexit – widely considered the worst-case economic scenario for the UK – further contributed to the pound’s depreciation against the euro.
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), further influencing the pound sterling to euro exchange rate.
Expectations
The depreciation of the pound sterling to euro exchange rate largely occurred before Brexit actually took place. Conversely, exchange rate movements were relatively minor when the UK officially left the EU and the transition period concluded at the end of 2020. This timing is explained by the significant role of investor expectations in triggering currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly integrated into currency markets due to the high volume and speed of trading. Any new information affecting currency expectations quickly reflects in exchange rates. If market participants foresee a negative future impact on investments in a currency, they will sell that currency, causing its value to fall, thus affecting the pound sterling to euro exchange rate.
The unprecedented drop in the pound after the referendum demonstrates the swift 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 subsequent collapse in the pound’s value immediately after the result underscores the negative expectations financial market participants held for sterling investments once the outcome was clear, significantly impacting the pound sterling to euro exchange rate.
The substantial 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, increased optimism about an orderly Brexit and a trade deal preceded increases in the pound’s value, showcasing the sensitivity of the pound sterling to euro exchange rate to market sentiment.
Recent studies have highlighted specific links between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). These findings suggest that market participants factor in the level of policy uncertainty when forming their expectations, directly influencing currency valuations like the pound sterling to euro exchange rate.
Consequences of Sterling’s Depreciation
An immediate consequence of a weaker pound sterling to euro exchange rate is that goods, services, and assets from the Eurozone become more expensive for UK residents. This leads to increased inflation and a higher cost of living.
However, a weaker currency can also offer benefits by making exports more competitive. By reducing the cost of UK goods and services for Eurozone residents, it can potentially improve the UK’s trade deficit and contribute to overall economic growth. This dynamic is central to understanding the multifaceted impact of the pound sterling to euro exchange rate.
Research on the overall impact of currency depreciation remains inconclusive. Furthermore, ongoing uncertainty about the extent and implications of post-Brexit trade frictions adds complexity, making the long-term economic outcome for the UK even less clear. Further research is essential to fully understand the lasting consequences of the Brexit-related decline in the pound sterling to euro exchange rate and its broader economic implications.
Further Reading
Experts on Pound Sterling and Euro Exchange Rates:
- 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)
