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, just before the vote on the UK’s European Union (EU) membership. Looking further back, the pound was even weaker, standing at 20% below its value when the EU Referendum Act was enacted in December 2015.
The past five years have shown Brexit as a major catalyst for exchange rate fluctuations, particularly impacting the pound’s value relative to leading global currencies like the euro. The immediate aftermath of the referendum delivered a stark illustration of this, with the pound experiencing its most dramatic single-day drop in three decades. Further substantial and sustained declines 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 devaluation was largely attributed to growing expectations of increased trade barriers between the UK and the EU, 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 sales increased, the pound’s value decreased in comparison to other currencies, most notably the euro.
The Mechanics of Exchange Rate Fluctuations
An exchange rate represents the price of one currency in relation to another. Like any price in a market economy, it is governed by the principles of supply and demand. In the context of currency exchange, when demand for one currency in a pair increases while the other’s decreases, the former will appreciate in value, and the latter will depreciate.
The post-referendum decline in the pound’s value signifies a decrease in the demand to hold pounds relative to other currencies, especially the euro. To fully grasp the underlying reasons for these Brexit-related exchange rate shifts, it’s crucial to understand the factors that influence currency demand.
Key Players in Currency Exchange Markets
Businesses engaged in international trade are significant participants in currency markets. This includes companies involved in importing and exporting goods and services, as well as individual travelers exchanging currency for international travel. For example, when a UK business imports goods from a Eurozone country, they need to convert pounds into euros, thereby increasing the demand for euros. Significant shifts in international trade flows can therefore impact currency demand and valuation.
However, the rapid and substantial drops in the pound’s value since 2016 happened before any actual changes to the UK-EU trading relationship were implemented. Furthermore, trade in goods and services isn’t the primary driver of overall foreign exchange transactions and typically doesn’t change dramatically in the short term (Bank for International Settlements, BIS, 2019). This indicates that fluctuations in goods and services trade are not the main cause of extreme exchange rate volatility and may not be the primary reason for the Brexit-related pound devaluation.
A more critical factor behind the sharp pound declines post-2016 is the significant decrease in the inclination of financial institutions to hold pound-denominated investments. Trading currencies for investment purposes, or trading in financial assets, constitutes the largest proportion of currency transactions and is usually the most significant driver of exchange rate changes, particularly in the short run.
This type of capital is often termed “hot money” – highly mobile capital that can move swiftly and in large volumes between investments or currencies, leading to rapid exchange rate impacts. 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. In contrast, only 4.9% of currency exchange volume was directly attributable to non-financial customers (BIS, 2019).
Additionally, 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 been increasingly financed by these capital inflows, making the currency sensitive to shifts in investor sentiment.
Brexit’s Impact on the Pound’s Appeal
Financial institutions in currency markets primarily react to factors that influence the returns on investments in different currencies. Therefore, the post-Brexit pound devaluation suggests that financial market participants anticipated that investments in pound-denominated assets would perform worse after the Brexit vote than they would have otherwise.
Several factors can influence returns in currency markets, and isolating their individual effects is complex. However, key factors generally include changes in relative interest rates, shifts in perceived risk, and alterations in overall investor expectations.
Interest Rates
Changes in interest rates, or factors impacting them, are considered major drivers of exchange rates. This is because domestic interest rates can affect the relative returns of assets in different countries. A decrease in a country’s interest rates means that assets linked to that rate will yield lower returns. An unexpected interest rate cut (assuming other factors remain constant) will lead to reduced demand for those assets compared to similar assets in other currencies, causing the currency’s value to fall.
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 program of ‘quantitative easing‘ (QE). It’s important to note, however, that this policy change was announced weeks after the Brexit vote. Therefore, the substantial pound devaluation in June 2016, and in subsequent years, cannot be solely explained by financial market reactions to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in perceived risk can also impact expected returns and influence investor decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors like future business performance, economic forecasts, interest rates, and political stability can make holding assets in a particular currency riskier, reducing or delaying 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 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 regarding post-Brexit trade relationships and the anticipated economic consequences. The most significant and sustained pound depreciations since 2016 were closely linked to heightened uncertainty and associated political turmoil.
One of the most significant drops in the pound’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 did not rule out a ‘no-deal’ Brexit – widely considered the worst-case economic scenario for the UK.
Evidence indicates 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
The pound’s devaluation largely preceded the actual implementation of Brexit. Conversely, exchange rate movements were relatively minor 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 in 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 affecting currency expectations is quickly reflected in exchange rates. If market participants anticipate a negative future impact on investments in a currency, they will sell it, causing its value to decline.
The record pound devaluation post-referendum demonstrates the rapid impact of changing market expectations on currencies, as the Leave vote surprised many analysts. Last-minute polls suggested a Remain victory, initially causing the pound to appreciate in the days leading up to the referendum. The pound’s collapse immediately after the result underscores the negative expectations financial market participants held for pound investments once the outcome was clear.
The significant pound declines in 2017 and 2019 occurred during periods of heightened political uncertainty. These declines also reflect increasingly negative expectations for sterling-denominated investments driven by the growing likelihood of a ‘hard’ Brexit. Conversely, improved prospects for an orderly Brexit and a trade deal led to increases in the pound’s value.
Recent research has highlighted 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, significantly influencing currency valuations like the pound vs euro exchange rate.
Consequences of a Weaker Pound
A direct consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK residents. This contributes to higher inflation and an increased cost of living.
However, a weaker currency can also be advantageous by making exports more competitive. It reduces the cost of domestic goods and services for international buyers. This can potentially benefit a country’s trade balance and overall economic growth by boosting exports.
Research on the net impact of currency depreciation is mixed. Furthermore, ongoing uncertainty surrounding the scale and implications of post-Brexit trade frictions complicates the likely long-term economic outcome for the UK. Further research is needed to fully understand the lasting consequences of the Brexit-related pound devaluation, particularly in its relationship with currencies like the euro.
Further Reading and Expert Insights
Experts on Exchange Rate Dynamics:
- 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)
