At the beginning of 2021, the British pound stood significantly weaker against the euro, approximately 15% lower than its value on the eve of the UK’s EU membership referendum in June 2016. This devaluation is even more stark when compared to December 2015, when the EU Referendum Act received Royal Assent, marking a 20% decrease in the pound’s value.
Brexit has emerged as a dominant factor influencing exchange rate volatility over the past half-decade, particularly impacting the Pound To Euro exchange rate and its standing against other major global currencies. The immediate aftermath of the 2016 referendum witnessed the most dramatic impact, with sterling experiencing its most substantial single-day drop in three decades. Further significant and sustained declines occurred in 2017 and 2019, culminating in new lows for the pound against both the euro and the dollar in August 2019, as illustrated in Figure 1.
This depreciation was largely driven by growing expectations of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and persistent political instability. These factors led financial institutions to divest from the pound. As organizations increasingly sold off assets denominated in sterling, the pound to euro exchange rate, and its value against other currencies, was driven downwards.
Understanding Exchange Rate Dynamics
An exchange rate represents the price of one currency in relation to another. These rates fluctuate based on 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 demand shifts. Increased demand for a currency drives its value up, while increased selling pressure pushes it down.
The post-referendum decline in the pound to euro exchange rate essentially reflects a reduced demand to hold the pound compared to other currencies. To grasp the underlying reasons for Brexit-related exchange rate movements, it’s crucial to identify the factors that influence the demand for a currency.
Key Players in Exchange Rate Fluctuations
Participants in international trade, dealing in goods and services, play a vital role in currency markets. This includes multinational corporations engaged in cross-border trade and individual travelers exchanging currency for international travel. For instance, when a UK entity purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars and potentially influencing the pound to dollar exchange rate. Significant shifts in international trade patterns can therefore impact currency demand and valuation.
However, the rapid and substantial weakening of the pound to euro exchange rate, and against other currencies, since 2016 predates any actual alterations in the trading relationship between the UK and the EU. Moreover, the volume of trade in goods and services isn’t the primary driver of overall foreign exchange transactions, and it typically doesn’t undergo sharp 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 volatility and may not be the main reason behind the Brexit-related fall in the pound to euro exchange rate.
A critical factor contributing to the sharp declines in the pound’s value since 2016 is a significant decrease in the inclination of financial institutions to hold investments denominated in pounds. Currency trading for investment purposes, or the trading of financial assets, constitutes the largest share of currency transactions and is typically the most significant driver of exchange rate changes, particularly 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, causing rapid exchange rate fluctuations. 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. Direct currency exchange volume attributable to non-financial customers was a mere 4.9% (BIS, 2019).
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, exacerbates its reliance on international capital flows 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.
Brexit’s Impact on the Pound’s Appeal
Financial institutions operating in currency markets primarily respond to factors that influence the returns on investments in different currencies. Therefore, the Brexit-related depreciation of the pound to euro exchange rate indicates that financial market participants anticipated poorer performance from investments in pound-denominated assets following the Brexit vote than previously expected.
Numerous factors can potentially affect returns in currency markets, and isolating the individual effects can be complex. 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 major drivers of exchange rates. Domestic interest rates can impact the relative return on assets across different countries. Lower interest rates in a country reduce 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 compared to similar assets in other currencies. This, in turn, will cause the currency’s value to fall.
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, it’s important to note that this policy change was announced weeks after the Brexit vote. Therefore, the immediate and substantial fall in the pound to euro exchange rate in June 2016, or 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 can also affect expected returns and influence investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors like future business 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 increased likelihood of trade friction between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Pre-referendum research had predicted significant declines in foreign investment in the UK due to Brexit-related trade costs (Dhingra et al, 2016).
These risks were further compounded by substantial and persistent political instability in the UK, which prolonged and deepened uncertainty surrounding post-Brexit trade relationships and the anticipated economic outcomes. The most significant and sustained drops in the pound to euro exchange rate since 2016 have been closely linked to heightened uncertainty and associated political turmoil.
One of the most pronounced 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 and indicated a willingness to consider a ‘no-deal’ Brexit – widely regarded as 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 depreciation of the pound to euro exchange rate primarily occurred before Brexit actually materialized. In contrast, exchange rate movements were relatively muted when the UK formally left the EU and the transition period concluded at the end of 2020. This is because investor expectations are a crucial trigger explaining the timing of 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 impacting expectations about a currency is quickly 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 fall in the pound immediately after the referendum illustrates the rapid impact of changing market expectations on currencies, as the Leave vote surprised many observers. Last-minute polls suggested a likely Remain victory, initially causing sterling to appreciate in the days leading up to the referendum. The subsequent collapse in the pound to euro exchange rate immediately following the result underscores the negative expectations that financial market participants held regarding pound investments once the outcome became clear.
The substantial falls in the pound in 2017 and 2019 coincided with periods of heightened political uncertainty. These declines also reflected increasingly negative expectations for investments denominated in sterling, driven by the growing likelihood 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 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 forming their expectations.
Consequences of a Weaker Pound
One immediate consequence of a weaker pound to euro exchange rate is that foreign goods, services, and assets become more expensive for UK residents. This leads to higher inflation and an increased cost of living.
However, a weaker currency can also be advantageous, as it can enhance export competitiveness by lowering the cost of domestic goods and services for residents of other countries. This can potentially positively impact the country’s trade deficit and 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 makes the long-term economic outcome for the UK even more ambiguous. Further research is needed to fully understand the long-term consequences of the Brexit-related fall in the pound to euro exchange rate and its broader economic impact.
Further Reading and Expert Insights
For those seeking deeper insights, resources and expertise are available from:
- 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)
This analysis was prepared by Christopher Coyle.
