At the beginning of 2021, the British pound (GBP) was significantly weaker against the euro (EUR) compared to its position before the 2016 Brexit referendum. Specifically, the pound was approximately 15% lower against the euro than it was in June 2016, prior to the vote on the UK’s European Union (EU) membership. This devaluation is even more pronounced when considering the period before the formal legislative process began, with sterling being 20% weaker than it was in December 2015, when the EU Referendum Act received Royal Assent.
Brexit has emerged as a dominant factor influencing the volatility of exchange rates and the pound’s value against major global currencies over the past half-decade. The immediate aftermath of the referendum vote vividly illustrated this impact. The pound sterling experienced its most dramatic single-day decline in 30 years, a clear indication of market reaction to the referendum outcome. Further sustained and substantial drops 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.
This depreciation was largely driven by growing expectations of increased trade barriers between the UK and the EU, its largest trading partner. This, coupled with heightened uncertainty and persistent political instability, prompted financial institutions to sell off pound-denominated assets. As these organizations divested from sterling, the currency’s value decreased relative to others, most notably the euro.
Decoding Exchange Rate Fluctuations
An exchange rate represents the price of one currency in relation to another. Like any price in a market economy, it fluctuates based on the principles of supply and demand. In a currency pair, when demand for one currency increases and supply of the other increases, the former appreciates in value while the latter depreciates.
The post-referendum decline in the pound’s value fundamentally signifies a decrease in the demand to hold pounds relative to other currencies, particularly the euro. Therefore, understanding the underlying reasons for Brexit-related exchange rate movements requires identifying the factors that influence the demand for a specific currency.
Key Players in Exchange Rate Dynamics
Participants in international trade of goods and services are significant actors in currency markets. This includes multinational corporations engaged in cross-border commerce and individual travelers exchanging currencies for personal expenses. For instance, when a UK entity imports goods from the Eurozone, they must convert pounds into euros, thereby increasing the demand for euros and potentially influencing the GBP/EUR exchange rate. Significant shifts in international trade patterns can therefore impact currency demand and valuation.
However, the sharp and rapid depreciation of the pound since 2016 preceded any actual changes in the trade relationship between the UK and the EU. Moreover, trade in goods and services is not the primary driver of overall foreign exchange transactions and typically doesn’t exhibit rapid short-term fluctuations (Bank for International Settlements, BIS, 2019). This suggests that shifts in goods and services trade are not the primary cause of extreme exchange rate fluctuations and may not be the main reason for the Brexit-related pound devaluation.
A critical factor behind the pound’s sharp depreciation since 2016 is the substantial reduction in financial institutions’ preference to hold investments denominated in pounds. Trading currencies for investment purposes, or the trade in financial assets, constitutes the largest segment of currency transactions and is typically the most significant driver of exchange rate changes, especially in the short term.
This type of capital is often referred to as ‘hot money’ – highly mobile capital that can quickly move between investments or currencies on a large scale, leading to rapid exchange rate adjustments. Consequently, the most influential participants in currency markets are financial institutions, including 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, leads to a current account deficit. This deficit increases reliance on external financing and renders the pound more susceptible to international capital flows. The current account deficit has been increasingly funded by these capital inflows, making the currency more vulnerable to shifts in investor sentiment.
Brexit’s Impact on the Pound’s Appeal
The primary drivers influencing financial institutions’ decisions in currency markets are factors affecting the returns on investments in different currencies. The Brexit-related pound devaluation indicates that financial market participants believed that investments in pound-denominated assets would perform less favorably post-Brexit than they would have otherwise.
Numerous factors can influence returns in currency markets, making it challenging to isolate individual effects. However, key factors typically include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations.
Interest Rates
Changes in interest rates, or factors influencing them, are considered a primary driver of exchange rates. Domestic interest rates can affect the relative attractiveness of assets in different countries. A decrease in a country’s interest rates reduces the returns 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 offering higher returns. This decreased demand subsequently causes a depreciation of the currency in question.
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 (QE) program. However, it’s crucial to note that this policy change was announced weeks after the Brexit vote. The significant pound devaluation in June 2016, and in subsequent years, cannot be solely attributed to financial market reactions to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in risk perception also significantly impact expected returns and influence investor decisions regarding asset and currency holdings. Increased uncertainty surrounding factors like future business performance, economic forecasts, interest rate trajectories, and political stability can elevate the perceived risk of holding assets in a specific currency. This increased risk can deter or postpone investment inflows (Pindyck, 1991).
The high probability of increased trade friction between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. 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 compounded by significant and ongoing political instability in the UK, which prolonged and deepened uncertainty regarding post-Brexit trade relationships and the anticipated economic consequences. The most substantial and persistent pound depreciations since 2016 were closely linked to heightened uncertainty and associated political turmoil.
A notable drop 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, coinciding with his refusal 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 for 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 largely occurred before Brexit formally took place. Conversely, exchange rate movements were less pronounced when the UK officially left the EU and the transition period concluded at the end of 2020. This is because investor expectations are a crucial catalyst in currency movements (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 affecting currency expectations is swiftly reflected in exchange rates. 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 pound depreciation after the referendum underscores the rapid impact of changing market expectations on currencies. The Leave vote surprised many commentators, as last-minute polls suggested a 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 revealed the negative expectations financial market participants held for sterling investments once the outcome became clear.
The significant pound depreciations in 2017 and 2019, during periods of heightened political uncertainty, also reflected increasingly negative expectations for pound-denominated investments due to the growing likelihood 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 demonstrated specific links between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). Findings suggest that market participants factor in the level of policy uncertainty when formulating their expectations, which in turn impacts currency valuations.
Consequences of a Weaker Pound
An immediate consequence of pound depreciation is that imported goods, services, and assets become more expensive for UK residents. This directly contributes to higher inflation and an increased cost of living.
However, a weaker currency can also offer potential benefits by making exports more competitive. Reduced costs of domestic goods and services for international buyers can potentially improve a country’s trade deficit and stimulate overall economic growth.
Research on the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the extent and implications of post-Brexit trade frictions complicates predictions for the UK’s economic outlook. Understanding the long-term consequences of the Brexit-related pound devaluation requires further in-depth research.
Further Reading
- Bank for International Settlements (BIS). (2019). Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) derivatives markets in 2019.
- Beckmann, J., & Czudaj, R. (2017). Economic policy uncertainty and exchange rate dynamics. Journal of International Money and Finance, 73, 1-17.
- Bloom, N., Bunn, P., Chen, S., Mizen, P., Smietanka, P., & Theriault, T. (2019). The impact of Brexit on UK firms. Bank of England.
- Dhingra, S., Ottaviano, G. I. P., Sampson, T., & Van Reenen, J. (2016). The consequences of Brexit for UK trade and living standards. Centre for Economic Performance, London School of Economics and Political Science.
- Dornbusch, R. (1976). Expectations and exchange rate dynamics. Journal of Political economy, 84(6), 1161-1176.
- Engle, C. M., & West, K. D. (2005). Exchange rate models. Journal of Economic literature, 43(2), 493-535.
- Pindyck, R. S. (1991). Irreversibility, uncertainty, and investment. Journal of economic literature, 29(3), 1110-1148.
Experts on Exchange Rates and Brexit Impact
- 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)
