Since the UK referendum on European Union membership in June 2016, the exchange rate between the pound sterling and the euro has become a closely watched indicator of economic sentiment and the impact of Brexit. At the beginning of 2021, the pound was about 15% weaker against the euro compared to its value before the referendum, and 20% weaker than when the EU Referendum Act was enacted in December 2015. This shift reflects significant market reactions and adjustments to the evolving relationship between the UK and the EU.
Over the past five years, Brexit has emerged as a primary driver of volatility and fluctuations in the Pound Sterling To Euro Rate, and its value against other major currencies. The immediate aftermath of the 2016 referendum witnessed the most dramatic single-day drop in sterling’s value in three decades. Further substantial 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 expectations of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and ongoing political instability. These factors led financial institutions to reduce their holdings of pound-denominated assets, selling off sterling and consequently driving down its value relative to currencies like the euro. As organizations divested from sterling, the pound sterling to euro rate adjusted to reflect this decreased demand.
The Mechanics of Exchange Rate Fluctuations
To understand the dynamics of the pound sterling to euro rate, it’s essential to grasp the fundamental principles of exchange rate determination. An exchange rate represents the price of one currency in terms of another. These rates are not fixed; they fluctuate based on the forces of supply and demand in the foreign exchange market.
When demand for a particular currency increases, its value appreciates relative to other currencies. Conversely, if demand decreases, the currency depreciates. In the context of the pound sterling to euro rate, the post-referendum decline signifies a reduced demand for holding pounds compared to euros. Therefore, examining the factors that influence the demand for a currency is crucial to understanding the movements in the pound sterling to euro rate in the Brexit era.
Key Players Influencing the Pound to Euro Rate
Participants in the international trade of goods and services play a significant role in currency markets. Corporations engaged in cross-border trade and individual travelers exchanging currencies for international transactions are familiar actors. For instance, when a UK entity imports goods from the Eurozone, it needs to convert pounds into euros, thereby increasing the demand for euros and influencing the pound sterling to euro rate. Significant shifts in international trade patterns can indeed impact currency valuations.
However, the sharp and rapid depreciation of the pound sterling to euro rate following the 2016 referendum preceded any actual changes in the trade relationship between the UK and the EU. Moreover, the volume of trade in goods and services is not the primary driver of daily foreign exchange transactions and typically does not exhibit sudden, drastic changes in the short term. This suggests that factors beyond trade in goods and services have been the main catalysts for the extreme fluctuations in the pound sterling to euro rate associated with Brexit.
The primary driver behind the significant drops in the pound sterling to euro rate since 2016 is the marked decrease in the inclination of financial institutions to hold investments denominated in pounds. Trading currencies for investment purposes, or trading in financial assets, constitutes the majority of currency transactions and is typically the most influential factor in exchange rate movements, especially in the short run.
This type of capital flow is often referred to as ‘hot money’ – highly mobile capital that can swiftly move between investments or currencies on a large scale, rapidly affecting exchange rates. Consequently, the most influential participants in currency markets are financial institutions such as banks, investment firms, and institutional investors who make decisions on vast portfolios and react quickly to perceived changes in investment attractiveness.
In 2019, financial institutions (excluding foreign exchange dealers) accounted for 57.8% of foreign exchange turnover in the UK, while only 4.9% of currency exchange volume was directly attributed to non-financial customers. Furthermore, the UK’s persistent trade deficit, where imports exceed exports, increases its reliance on international capital inflows to finance this deficit. This dynamic makes the pound more susceptible to the movements of international capital and, consequently, more sensitive in the pound sterling to euro rate.
Brexit’s Impact on Pound Sterling’s Appeal
The fluctuations in the pound sterling to euro rate and the pound’s overall depreciation in the wake of Brexit indicate that financial markets perceived investments in pound-denominated assets as less favorable compared to before the referendum. Financial institutions respond primarily to factors affecting the expected returns on investments in different currencies.
Several factors can influence returns in currency markets, and isolating the impact of each is complex. However, key factors generally include changes in relative interest rates, shifts in perceived risk, and alterations in overall investor expectations. These elements have collectively contributed to the movements observed in the pound sterling to euro rate.
Interest Rate Dynamics and the Pound Euro Rate
Changes in interest rates are widely recognized as a major determinant of exchange rates. Domestic interest rates can significantly influence the relative attractiveness of assets across different countries. Lowering interest rates in a country reduces the returns on assets linked to that rate. An unexpected decrease in interest rates, all else being equal, will lead to decreased demand for those assets relative to similar assets in other currencies, causing a depreciation in the currency’s value. This mechanism directly impacts the pound sterling to euro rate.
For instance, following the Leave vote, the Bank of England lowered interest rates in August 2016 from 0.5% to 0.25% and expanded its quantitative easing program. However, it’s crucial to note that this policy change occurred weeks after the Brexit referendum. Therefore, the immediate and substantial fall in the pound sterling to euro rate in June 2016, and subsequent years, cannot be solely attributed to financial market reactions to this specific interest rate adjustment.
Uncertainty, Political Instability, and Currency Valuation
Shifts in risk perception also play a critical role in influencing expected returns and shaping investors’ decisions about which currencies and assets to hold. Increased uncertainty surrounding factors such as future business performance, economic forecasts, interest rate paths, and political stability can elevate the perceived risk of holding assets in a specific currency. This increased risk can deter or delay investment inflows, negatively impacting the currency’s value and affecting the pound sterling to euro rate.
The heightened probability of increased trade frictions between the UK and the EU post-Brexit significantly 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.
These risks were further compounded by considerable and persistent political instability in the UK. This prolonged uncertainty about post-Brexit trade relationships and the likely economic outcomes. The most significant and sustained declines in the pound sterling to euro rate since 2016 have been closely correlated with periods of heightened uncertainty and associated political turmoil.
One of the most pronounced drops in the pound sterling to euro rate 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 and indicated a willingness to consider a ‘no-deal’ Brexit – widely considered the most adverse economic scenario for the UK.
Evidence suggests that the negative effects of this uncertainty on employment, productivity, and investment within UK businesses became increasingly apparent in the years immediately following the referendum. This climate of uncertainty has been a significant factor in the fluctuations of the pound sterling to euro rate.
The Role of Investor Expectations in Exchange Rates
Interestingly, the most significant depreciation of the pound sterling to euro rate occurred before Brexit actually materialized. In contrast, exchange rate movements were relatively muted when the UK officially left the EU and the transition period concluded at the end of 2020. This timing underscores the crucial role of investor expectations in driving currency movements.
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 its exchange rate. If market participants anticipate a negative future impact on investments denominated in a particular currency, they will sell that currency, causing it to depreciate.
The record fall in the pound sterling to euro rate immediately after the referendum exemplifies the swift impact of shifting market expectations. The Leave vote surprised many observers, as last-minute polls suggested a likely Remain victory, which had initially caused the pound to appreciate in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately following the result underscores the negative expectations that financial market participants developed regarding sterling investments once the outcome became clear.
The substantial declines in the pound sterling to euro rate in 2017 and 2019, during periods of heightened political uncertainty, also reflect increasingly pessimistic 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 have been associated with increases in the pound’s value. Research has established direct links between economic policy uncertainty and exchange rate expectations, highlighting that market participants factor in policy uncertainty when forming their outlook.
Consequences of a Weaker Pound Sterling
One immediate consequence of a weaker pound sterling to euro rate is that goods, services, and assets priced in euros become more expensive for UK residents and businesses. This directly contributes to increased inflation and a higher cost of living for UK consumers.
However, a weaker currency can also offer potential benefits. It can enhance the competitiveness of a country’s exports by making domestic goods and services cheaper for buyers in other countries. This can potentially improve the country’s trade balance and stimulate overall economic growth.
Research on the net effect of currency depreciation is varied. Furthermore, ongoing uncertainty regarding the extent and implications of post-Brexit trade frictions adds complexity, making the long-term economic outcome for the UK less clear. Further research is necessary to fully understand the enduring consequences of the Brexit-related depreciation in the pound sterling to euro rate.
Further Resources and Expert Insights
For those seeking deeper knowledge on this topic, resources and experts are available to consult.
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)
Further Reading:
- Bank for International Settlements (BIS) reports on foreign exchange markets.
- Centre for Economic Performance (CEP) Brexit analysis papers.
- Bank of England publications on monetary policy and economic analysis.
- Financial Times articles on currency markets and Brexit economics.
- VoxEU articles on economic policy and Brexit impacts.
This information should provide a comprehensive understanding of the factors influencing the pound sterling to euro rate in the context of Brexit and broader economic principles.
