Since the beginning of 2021, the UK pound has remained significantly weaker against the euro compared to its position before the 2016 Brexit referendum. Specifically, the pound was approximately 15% lower against the euro than it was on the eve of the vote to leave the European Union in June 2016. This devaluation is even more pronounced when considering the period before the referendum campaign gained momentum; the pound was 20% weaker than when the EU Referendum Act was enacted in December 2015.
The past half-decade has underscored Brexit’s pivotal role in driving volatility in the foreign exchange market and influencing the value of the pound sterling against major global currencies, particularly the euro. The immediate aftermath of the referendum delivered a stark illustration of this impact. The pound experienced its most dramatic single-day plunge in three decades, signaling the market’s abrupt reassessment of the UK’s economic prospects. This initial shock was followed by further substantial and sustained declines in 2017 and 2019, culminating in the pound reaching new lows against both the euro and the US dollar by August 2019, as depicted in Figure 1.
This devaluation was largely attributed to the anticipation of increased trade barriers between the UK and the EU, its largest trading partner. Coupled with this was a surge in uncertainty and persistent political instability within the UK. These factors collectively prompted financial institutions to reduce their holdings of pound-denominated assets, triggering a sell-off of sterling. As more institutions divested from the pound, its value depreciated relative to other currencies, most notably the euro.
Understanding Exchange Rate Dynamics
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 fundamental principles of supply and demand. In the context of currency exchange, when demand for a particular currency increases, its value appreciates, while the value of the counter currency in the pair depreciates. Conversely, decreased demand leads to depreciation.
The post-referendum decline in the pound’s value fundamentally reflects a decrease in the global demand to hold sterling relative to other currencies, particularly the euro. To comprehensively understand the Brexit-related exchange rate fluctuations, it’s crucial to examine the underlying factors that influence the demand for a currency in the international market.
Key Players in Currency Exchange Markets
Organizations engaged in international trade of goods and services are essential participants in the foreign exchange market. This includes multinational corporations involved in cross-border trade and individual travelers exchanging currencies for tourism or business trips. For instance, when a UK entity imports goods from a Eurozone country, it must convert pounds into euros, thus increasing the demand for euros and potentially influencing the exchange rate. Significant shifts in international trade flows can therefore impact currency demand and valuation.
However, the rapid and substantial depreciation of the pound following the 2016 referendum predates any tangible alterations in the trading relationship between the UK and the EU. Furthermore, trade in goods and services constitutes a relatively small proportion of overall foreign exchange transactions and typically does not exhibit sharp short-term fluctuations (Bank for International Settlements, BIS, 2019). This suggests that while trade is a factor, it is not the primary driver behind the extreme exchange rate volatility observed post-Brexit, and likely not the main cause of the pound’s depreciation against the euro.
The primary catalyst for the sharp decline in the pound’s value since 2016 is the considerable 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 largest segment of currency transactions and is generally the most significant determinant of exchange rate movements, particularly in the short term.
This investment-driven currency flow is often referred to as “hot money” – capital that is highly mobile and can swiftly move between investments or currencies on a massive scale, exerting rapid influence on exchange rates. Consequently, the most influential actors in currency markets are financial institutions, including 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 stark contrast, only 4.9% of currency exchange volume was directly attributable to non-financial customers (BIS, 2019).
Adding to the pound’s vulnerability is the UK’s persistent current account deficit, where imports consistently exceed exports. This deficit increases reliance on international capital inflows to balance the books, making the pound more susceptible to shifts in global investment sentiment. The current account deficit has become increasingly reliant on these capital inflows for financing.
Brexit’s Impact on Pound Sterling’s Appeal
Financial institutions, the dominant force in currency markets, primarily react to factors that affect the expected return on investments in different currencies. The post-Brexit depreciation of the pound against the euro indicates that financial market participants perceived investments in pound-denominated assets as less attractive following the referendum vote.
While numerous factors can influence returns in currency markets, and isolating the precise impact of each is complex, key drivers typically include changes in relative interest rates, shifts in risk perception, and evolving investor expectations.
Interest Rates
Adjustments in interest rates, or factors influencing interest rates, are widely recognized as primary drivers of exchange rates. Domestic interest rates impact the relative attractiveness of assets in different countries. A decrease in a country’s interest rates reduces the yield on assets linked to that rate. An unexpected interest rate cut, all else being equal, diminishes demand for those assets relative to comparable assets in other currencies, leading to a depreciation of the currency in question.
For instance, in response to the Brexit 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 response occurred weeks after the Brexit vote. Therefore, the significant initial plunge in the pound’s value in June 2016, and subsequent declines, cannot be solely attributed to financial market reactions to this specific interest rate adjustment.
Uncertainty and Political Instability
Changes in perceived risk also profoundly affect expected returns and influence investor decisions regarding asset allocation, including currency holdings. Heightened uncertainty surrounding factors such as future business performance, economic prospects, interest rate trajectories, and political stability can elevate the risk associated with holding assets in a specific currency. This increased risk can reduce or delay investment inflows (Pindyck, 1991).
The increased likelihood of trade frictions between the UK and the EU post-Brexit 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 (Dhingra et al, 2016).
These risks were further compounded by significant and persistent political instability in the UK. This prolonged and deepened the uncertainty surrounding post-Brexit trade relationships and the overall economic outlook. The most substantial and sustained depreciations of the pound since 2016 were closely correlated with periods of heightened uncertainty and associated political turmoil.
A notable example is the sharp fall in sterling’s value against the euro in 2017, which followed an early general election resulting in a hung parliament. Similarly, in 2019, the pound plummeted 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 most adverse economic scenario for the UK.
Evidence suggests that the negative consequences of this uncertainty on employment, productivity, and investment within UK businesses became increasingly apparent in the years immediately following the referendum (Bloom et al, 2019).
Expectations
The pound’s depreciation largely occurred before Brexit formally took place. Conversely, exchange rate movements were comparatively muted when the UK officially left the EU and the transition period concluded at the end of 2020. This timing highlights the crucial role of investor expectations in driving currency movements (Dornbusch, 1976; Engle and West, 2005).
Changes in investor expectations are rapidly incorporated into currency markets due to the immense volume and speed of trading. Any new information affecting expectations about a currency’s future prospects is swiftly reflected in exchange rates. If market participants anticipate a negative future impact on investments in a specific currency, they will sell that currency, causing its value to decline.
The record-breaking fall of the pound immediately after the referendum exemplifies the rapid impact of shifting market expectations. The Leave vote surprised many analysts, as 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’s value underscores the negative expectations financial market participants held for sterling investments once the referendum outcome became clear.
The significant pound depreciations in 2017 and 2019 coincided with periods of heightened political uncertainty. These declines 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 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). These findings indicate that market participants factor in the level of policy uncertainty when formulating their exchange rate expectations.
Consequences of a Weaker Pound Sterling
A direct consequence of a weaker pound is that goods, services, and assets priced in foreign currencies become more expensive for UK residents. This leads to increased inflation and a higher cost of living for consumers in the UK.
However, a weaker currency can also offer potential benefits. It can enhance export competitiveness by reducing the cost of domestically produced goods and services for international buyers. This could potentially improve the country’s trade deficit and contribute to overall economic growth.
Research examining the net effect of currency depreciation is inconclusive. Furthermore, ongoing uncertainty surrounding the magnitude and implications of post-Brexit trade frictions makes the long-term economic consequences for the UK even more ambiguous. Further research is necessary to fully understand the lasting effects of the Brexit-related decline in the value of the pound sterling.
