At the beginning of 2021, the British pound (£) was significantly weaker against the euro (€) compared to its position before the 2016 Brexit referendum. Specifically, the pound was about 15% lower against the euro than it was in June 2016, before the vote, and a full 20% weaker than in December 2015, when the EU Referendum Act was formalized. This dramatic shift highlights the profound impact of Brexit on the Pound Sterling To Euro exchange rate.
Brexit has undeniably been a primary driver of volatility in the exchange rate and the overall value of the pound against major global currencies over the past half-decade. The immediate aftermath of the referendum delivered a stark illustration of this, with sterling experiencing its most significant single-day drop in 30 years. Further substantial and sustained declines occurred in both 2017 and 2019, pushing the pound to new lows against both the euro and the US dollar by August 2019, as visualized in Figure 1.
This depreciation largely stemmed from growing expectations of increased trade barriers between the UK and the European Union, its largest trading partner. Coupled with heightened uncertainty and ongoing political instability, these factors prompted financial institutions to sell off pound-denominated assets. As the volume of sterling asset sales increased, the value of the pound naturally decreased relative to other currencies, impacting the pound sterling to euro exchange rate and other currency pairs.
The Mechanics of Exchange Rate Fluctuations
An exchange rate, at its core, is simply the price of one currency expressed in terms of another. These rates are dynamic, 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) as market participants increase their demand for the former and sell off the latter.
The post-referendum weakening of the pound sterling signifies a decrease in the global demand to hold pounds relative to other currencies like the euro. To fully grasp the underlying causes of Brexit-related exchange rate movements, particularly the pound sterling to euro rate, it’s essential to understand the factors that influence the demand for a currency.
Key Players in Exchange Rate Dynamics
Businesses engaged in international trade are significant and well-established players in currency markets. This includes corporations involved in cross-border sales of goods and services, as well as individual travelers exchanging currency for personal spending. For instance, when a UK business or resident purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars and influencing the pound sterling to US dollar exchange rate. Large shifts in international trade patterns can therefore significantly alter the demand for, and consequently the value of, a currency.
However, the rapid and substantial drops in the pound’s value since 2016 occurred before any actual changes in the trade relationship between the UK and the EU had materialized. Moreover, trade in goods and services isn’t the primary source of overall foreign exchange transactions and typically doesn’t fluctuate dramatically in the short term (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade are not the primary drivers of extreme exchange rate volatility and may not be the main reason behind the Brexit-related decline in the pound’s value against the euro and other currencies.
A critical factor behind the sharp declines in the value of the pound since 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 portion of currency transactions and is generally 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 be rapidly shifted between investments or currencies on a large scale, causing swift impacts on exchange rates, including the pound sterling to euro rate. Consequently, the most influential participants in currency markets are financial institutions such as banks, securities 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 attributed to non-financial customers (BIS, 2019).
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, increases its reliance on international capital inflows and makes the pound more susceptible to the movements of global capital. This vulnerability arises because the current account deficit has been increasingly financed by these capital inflows, leaving the pound sterling to euro exchange rate sensitive to investor sentiment.
Brexit’s Impact on Pound Sterling’s Appeal
The primary factors that financial institutions consider in currency markets are those that affect the returns on investments in different currencies. Therefore, the Brexit-related decline in the pound’s value indicates that financial market participants believed that investments in pound-denominated assets would perform worse after the Brexit vote than they would have otherwise.
While numerous factors can influence returns in currency markets, making it challenging to isolate individual effects, some of the most crucial are typically shifts in relative interest rates, changes in perceived risk, and evolving investor expectations.
Interest Rates
Changes in interest rates, or factors influencing them, are widely recognized as a primary driver of exchange rates, including the pound sterling to euro rate. Domestic interest rates can impact the relative return on assets in different countries. A decrease in a country’s interest rates means that assets linked to that rate will yield a lower return. An unexpected interest rate cut (assuming other factors remain constant) will lead to reduced demand for those assets, relative to similar assets in other currencies. This, in turn, will cause 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 financial market participants’ reaction to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in risk perception can also impact expected returns and influence investors’ decisions about which assets, including currencies, to hold. Increased uncertainty surrounding factors like future corporate performance, economic forecasts, interest rate trajectories, and political stability can make holding assets in a particular currency riskier, leading to reduced or delayed 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, directly affecting the pound sterling to euro exchange rate. 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, which prolonged and deepened uncertainty regarding post-Brexit trade relationships and the anticipated economic outcomes. The most substantial and sustained declines in the pound since 2016 were closely correlated with periods of heightened uncertainty and associated political turmoil.
One of the most significant drops in sterling’s value against the euro occurred in 2017. This followed 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 and refused to rule out a ‘no-deal’ Brexit – widely considered the worst-case economic scenario for the UK.
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).
Expectations
Crucially, the depreciation of the pound largely occurred before Brexit actually took place. 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 play a vital role in triggering currency movements (Dornbusch, 1976; Engle and West, 2005).
Shifting investor expectations are rapidly incorporated into currency markets due to the sheer 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 sterling to euro 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 of the pound after 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, which initially caused the pound 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 that financial market participants held for sterling investments once the outcome became clear, significantly impacting the pound sterling to euro exchange rate.
The substantial drops 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 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 expectations, which directly influences currency valuations like the pound sterling to euro rate.
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 residents. This translates to higher inflation rates and an increased cost of living. For individuals looking to convert pound sterling to euro, this means receiving fewer euros for their pounds.
However, a weaker currency can also offer benefits by making exports more competitive. By reducing the cost of domestic goods and services for residents of other countries, it can potentially improve a country’s trade deficit and stimulate overall economic growth. This could, in theory, lead to a rebalancing of the pound sterling to euro exchange rate over time.
Research on the net effect of currency depreciation is, at best, mixed. Furthermore, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions makes the long-term economic outlook for the UK, and consequently the future of the pound sterling to euro exchange rate, even more uncertain. Further research is needed to fully understand the longer-term consequences of the Brexit-related fall in sterling.
Further Reading and Expert Insights
For deeper exploration of this topic, consider researching the work of experts in the field:
- 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)
By understanding the complex interplay of factors influencing the pound sterling to euro exchange rate, particularly in the context of Brexit, individuals and businesses can better navigate the financial landscape and make informed decisions.
By Christopher Coyle
Photo by PublicDomainPictures from Pixabay
