At the beginning of 2021, the British pound was approximately 15% weaker against the euro compared to its value just before the UK’s referendum on European Union (EU) membership in June 2016. This represented a significant shift, with sterling also being 20% weaker than when the EU Referendum Act received Royal Assent in December 2015.
Brexit has emerged as a central factor influencing exchange rate fluctuations and the pound’s value against major currencies over the past half-decade. The impact of Brexit was immediately apparent following the referendum result, as the pound sterling experienced its most significant single-day drop in three decades. Further substantial and sustained declines occurred in 2017 and 2019, driving the pound to new lows against both the euro and the US dollar by August 2019, as illustrated in Figure 1.
Pound to Euro exchange rate fluctuation post Brexit
This depreciation largely stemmed from expectations of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and persistent political instability. These factors prompted financial institutions to sell off pound-denominated assets. As the volume of sterling assets sold increased, the pound’s value diminished relative to other currencies, particularly the euro.
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 strengthens its value, while increased selling pressure weakens it.
Fundamentally, the decline in the pound’s value since the Brexit referendum indicates a reduced demand to hold pounds compared to other currencies, especially the euro. To fully grasp the Brexit-related exchange rate movements, it’s crucial to identify the factors that influence the demand for a currency like the Pound Euro.
The Role of Market Participants in Exchange Rate Shifts
Businesses engaged in international trade of goods and services are key players in currency markets. This includes exporters and importers, as well as individuals traveling abroad and exchanging currency for personal spending. For example, when a UK business imports goods from the Eurozone, they must convert pounds into euros, thus increasing the demand for euros and potentially affecting the pound euro exchange rate. Significant changes in international trade flows can therefore impact the demand for and value of a currency.
However, the rapid and substantial falls in the pound’s value after 2016 happened before any actual changes in the UK-EU trading relationship were implemented. Furthermore, the volume of trade in goods and services is not the primary driver of overall foreign exchange transactions and tends to be relatively stable in the short term (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade are not the main cause of the extreme exchange rate fluctuations and may not be the primary reason for the Brexit-related decline in the pound euro exchange rate.
A more critical factor behind the sharp depreciation of the pound since 2016 is the significant reduction in the preference of financial institutions to hold investments denominated in pounds. Currency trading 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 changes, especially in the short run.
This type of capital movement 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 movements. Consequently, the most influential participants in currency markets are financial institutions, including 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. Direct currency exchange volume from non-financial customers was only 4.9% (BIS, 2019).
Additionally, the UK’s persistent trade deficit, where imports exceed exports, leads to a reliance on external financing and makes the pound more susceptible to international capital flows. This is because the current account deficit has been increasingly financed by these capital inflows, making the pound euro exchange rate more vulnerable to shifts in investor sentiment.
Brexit’s Impact on Pound Sterling’s Appeal
The primary factors that financial institutions consider in currency markets are those affecting the returns on investments in different currencies. Therefore, the Brexit-related fall in the pound euro exchange rate indicates that financial market participants believed that investments in pound-denominated assets would perform worse 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, key factors typically include changes in relative interest rates, shifts in risk perception, and changes in overall investor expectations.
Uncertainty and Political Instability Post-Brexit
Changes in risk perception significantly affect expected returns and influence investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors such as future business performance, economic prospects, interest rate trajectories, and political stability can make holding assets in a specific currency riskier. This heightened risk can reduce or delay investment inflows (Pindyck, 1991).
The increased likelihood of trade friction between the UK and the EU after Brexit amplified these risks for pound-denominated assets, impacting the pound euro exchange rate. 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 ongoing political instability in the UK. This prolonged and deepened the uncertainty surrounding post-Brexit trade relationships and the anticipated economic outcomes, impacting the pound euro rate negatively. The most significant and persistent declines in the pound euro exchange rate since 2016 were closely linked to increased uncertainty and associated political turmoil.
For instance, one of the steepest falls 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 rule out a ‘no-deal’ Brexit scenario – widely considered the worst possible economic outcome for the UK – further exacerbated concerns and pressured the pound euro exchange rate.
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).
Interest Rate Adjustments and the Pound Euro
Changes in interest rates are considered a primary driver of exchange rates, including the pound euro rate. Domestic interest rates can influence the relative return on assets in different countries. A decrease in interest rates in a country reduces the return 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 with higher interest rates. 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 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 adjustment. While interest rate changes play a role, they were not the primary trigger for the initial and largest falls in the pound euro rate post-referendum.
The Power of Investor Expectations on the Pound Euro Rate
The decline in the pound euro exchange rate largely preceded the actual implementation of Brexit. Conversely, exchange rate movements were relatively muted when the UK officially left the EU and the transition period concluded at the end of 2020. This highlights the crucial role of investor expectations in driving 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 affects expectations about a currency’s future performance will be quickly reflected in exchange rates, including the pound euro rate. 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 fall of the pound euro exchange rate after the referendum exemplifies the rapid impact of changing market expectations on currencies, as the Leave vote surprised many observers. Pre-referendum polls suggested a likely Remain victory, which initially led to a pound appreciation 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 substantial declines in the pound euro rate in 2017 and 2019 coincided with periods of heightened political uncertainty. These falls also reflected increasingly negative expectations for pound-denominated investments driven by the growing probability of a ‘hard’ Brexit. Conversely, increased optimism regarding an orderly Brexit and a trade agreement preceded increases in the pound’s value, showing the sensitivity of the pound euro rate to shifting expectations.
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, which directly impacts currency valuations like the pound euro exchange rate.
Consequences of Pound Sterling Depreciation
A direct consequence of a weaker pound euro exchange rate is that goods, services, and assets from the Eurozone become more expensive for UK residents and businesses. This contributes to higher inflation and an increased cost of living in the UK.
However, a weaker currency can also offer benefits. It can enhance export competitiveness by making UK goods and services cheaper for residents of other countries, including the Eurozone. This could potentially have positive effects on the UK’s trade deficit and overall economic growth.
Research on the net impact of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the extent and consequences of post-Brexit trade frictions makes the long-term economic outlook for the UK, and the future of the pound euro exchange rate, even more uncertain. Further research is needed to fully understand the long-term consequences of the Brexit-related depreciation of the pound sterling.
Experts on this topic:
- 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)
