Since the beginning of 2021, the British pound has remained significantly weaker against the euro, approximately 15% lower than its value before the 2016 Brexit referendum. This devaluation is even more pronounced when compared to December 2015, when the EU Referendum Act was enacted, showing a 20% decrease.
Over the past half-decade, Brexit has emerged as a dominant factor influencing the volatility of exchange rates and the pound’s value against major global currencies. The immediate aftermath of the referendum vote vividly illustrated this impact, with sterling experiencing its most dramatic 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 illustrated in Figure 1.
This depreciation largely stemmed from anticipations 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, driving down the pound’s value relative to other currencies as selling pressure mounted.
Figure 1: Visual representation of the Pound/Euro daily exchange rate fluctuations between 2015 and 2021, highlighting the impact of Brexit.
Understanding Exchange Rate Dynamics
An exchange rate represents the price of one currency in relation to another. Like any price, it fluctuates based on the fundamental principles of supply and demand. In currency exchange, when demand for one currency within a pair increases while the other decreases, the former appreciates in value, and the latter depreciates.
The post-referendum decline in sterling’s value fundamentally reflects a reduced demand to hold pounds compared to other currencies. To grasp the underlying reasons for Brexit-related exchange rate movements, it’s crucial to understand the factors that influence currency demand.
Key Players in Exchange Rate Shifts
Entities engaged in international trade of goods and services are significant participants in currency markets. This includes multinational corporations involved in cross-border commerce and 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 relative to pounds. Significant shifts in international trade patterns can therefore impact currency demand and valuation.
However, the sharp and rapid depreciation of the pound following 2016 occurred before any tangible changes in the trade relationship between the UK and the EU. Moreover, trade in goods and services isn’t the primary driver of overall foreign exchange transactions and doesn’t typically experience abrupt short-term fluctuations (Bank for International Settlements, BIS, 2019). This suggests that factors beyond trade in goods and services were the main catalysts for the extreme exchange rate volatility and the Brexit-related pound devaluation.
A critical factor behind the pound’s sharp decline since 2016 is the substantial decrease in financial institutions’ inclination to hold pound-denominated investments. Currency trading for investment purposes, or trading in financial assets, constitutes the majority of currency transactions and is typically the most significant driver of exchange rate changes, especially in the short term.
This is often referred to as ‘hot money’ – highly mobile capital that can swiftly move between investments or currencies on a large scale, leading to 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. Direct transactions from non-financial customers represented a mere 4.9% of currency exchange volume (BIS, 2019).
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, increases its reliance on ‘the kindness of strangers’ and makes the pound more vulnerable to international capital flows. This vulnerability arises because the current account deficit has become increasingly dependent on these capital inflows for financing.
Brexit’s Impact on the Pound’s Appeal
The primary drivers influencing financial institutions’ decisions in currency markets are factors affecting investment returns across different currencies. Therefore, the Brexit-related pound devaluation indicates that financial market participants anticipated poorer performance for pound-denominated investments post-Brexit compared to their pre-referendum expectations.
Numerous factors can influence returns in currency markets, making it challenging to isolate individual effects. However, key factors typically include shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.
Interest Rates
Changes in interest rates, or factors influencing them, are considered primary drivers of exchange rates. Domestic interest rates impact the relative return on assets in different countries. Lower interest rates in a country reduce the returns on assets linked to that rate. An unexpected interest rate decrease (assuming other factors remain constant) diminishes demand for those assets relative to assets in other currencies, leading to a currency devaluation.
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, this policy change was announced weeks after the Brexit vote. The significant pound devaluation in June 2016 and subsequent years cannot be solely attributed to financial market reactions to this specific interest rate policy.
Uncertainty and Political Instability
Changes in risk perception 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 elevate the perceived risk of holding assets in a specific currency, reducing or delaying investment inflows (Pindyck, 1991).
The heightened probability of increased trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Pre-referendum research projected 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, prolonging and deepening uncertainty around post-Brexit trade relationships and the anticipated economic consequences. The most substantial and sustained pound depreciations since 2016 were closely linked to heightened uncertainty and associated political turmoil.
A notable instance of sterling’s devaluation against the euro occurred in 2017, following an early general election that resulted in a hung parliament. In 2019, the pound reached a new multi-year low against both the dollar and euro shortly after Boris Johnson became Prime Minister and did not rule out a ‘no-deal’ Brexit – widely considered the worst-case 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 devaluation primarily occurred before Brexit actually materialized. 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 is because investor expectations are a critical trigger explaining the timing of currency fluctuations (Dornbusch, 1976; Engle and West, 2005).
Shifting investor expectations are rapidly incorporated into currency markets due to the immense volume and speed of trading. Any new information impacting currency expectations is swiftly reflected in exchange rates. If market participants anticipate negative future impacts on investments in a currency, they will sell that currency, causing its value to decline.
The record pound devaluation following the referendum exemplifies the rapid impact of changing 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 pound collapse immediately after the result underscores the negative expectations financial market participants held for sterling investments once the outcome became clear.
The substantial pound declines in 2017 and 2019 occurred during periods of heightened political uncertainty. These declines also reflected 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 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 expectations.
Consequences of a Weaker Pound
A direct consequence of pound devaluation is that foreign goods, services, and assets 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 enhancing export competitiveness. It reduces the cost of domestic goods and services for international buyers, potentially improving the country’s trade deficit and fostering overall economic growth.
Research on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions complicates the long-term outlook for the UK economy. Further research is necessary to fully comprehend the long-term consequences of the Brexit-related pound devaluation.
Further Reading and Expert Insights
For deeper exploration of this topic, consider researching work by the following 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
Image source: PublicDomainPictures from Pixabay
