Since the beginning of 2021, the British pound has seen a notable decrease in value against the euro. It’s approximately 15% weaker than it was before the UK’s Brexit referendum in June 2016. Looking further back, Sterling is also about 20% weaker than it was in December 2015, when the EU Referendum Act was officially approved. This sustained shift in the Uk Sterling To Euro exchange rate raises important questions about the economic forces at play.
Over the past half-decade, Brexit has consistently been a primary driver of fluctuations in currency exchange rates, significantly affecting the pound’s value against major global currencies, especially the euro. The immediate aftermath of the 2016 referendum vividly illustrated this impact. Sterling experienced its most dramatic single-day drop in three decades, a clear indication of market reaction to the referendum outcome. This initial shock was followed by two more significant and lasting declines in 2017 and 2019. These drops pushed the value of sterling to new lows against both the euro and the US dollar by August 2019, as illustrated in Figure 1.
This devaluation largely stemmed from growing expectations of increased trade barriers between the UK and the European Union, its largest trading partner. Coupled with heightened uncertainty and ongoing political instability, these factors led financial institutions to reduce their holdings of the pound. As more institutions divested from assets denominated in sterling, the currency’s value decreased relative to others, particularly the euro.
Alt text: Figure 1: UK Sterling to Euro Exchange Rate Daily Chart 2015-2021. Demonstrates the fluctuations in the pound to euro exchange rate from 2015 to 2021, highlighting significant drops post-Brexit referendum and subsequent years.
The Dynamics of Exchange Rate Shifts
An exchange rate, at its core, is simply the price of one currency expressed in terms of another. Like any price in a market economy, it is governed by the principles of supply and demand. In a currency pair like uk sterling to euro, when demand for the pound increases and supply decreases relative to the euro, the pound’s value will appreciate (go up), and the euro will depreciate (go down). Conversely, increased demand for the euro and decreased demand for the pound will lead to the pound depreciating against the euro.
The post-referendum decline in the value of uk sterling to euro signifies a fundamental shift: a decrease in the global demand to hold pounds compared to other currencies. To fully grasp the Brexit-related exchange rate movements, we need to identify the key factors influencing the demand for a currency like the British pound.
Who are the Key Players in Exchange Rate Movements?
Businesses engaged in international trade are significant participants in currency exchange markets. These include companies that import and export goods and services, as well as individuals traveling abroad and needing to exchange currency for personal expenses. For instance, when a UK company imports goods from a Eurozone country, they must convert pounds into euros, thereby increasing the demand for euros and potentially affecting the uk sterling to euro exchange rate. Large shifts in international trade volumes can indeed influence currency demand and value.
However, the rapid and substantial depreciation of uk sterling to euro and other pairings after 2016 occurred before any actual changes in the trade relationship between the UK and the EU had taken effect. Furthermore, the volume of trade in goods and services is not the primary driver of overall foreign exchange transactions, nor does it typically fluctuate dramatically in the short term (Bank for International Settlements, BIS, 2019). This suggests that changes in goods and services trade may not be the primary cause of the extreme exchange rate volatility observed, and likely not the main reason for the Brexit-related fall in the value of sterling against the euro.
A more critical factor behind the sharp falls in uk sterling to euro exchange rates since 2016 is the considerable reduction in the preference of financial institutions to hold investments in pound-denominated assets. The trading of currencies for investment purposes, or trade in financial assets, constitutes the majority of currency transactions and is typically the most significant driver of exchange rate changes, particularly in the short run.
This type of capital flow is often referred to as ‘hot money’ – funds that are highly mobile and can be moved rapidly and in large volumes between different investments or currencies. These movements can have a swift and substantial impact on exchange rates, including the uk sterling to euro rate. Consequently, financial institutions such as banks, securities firms, and institutional investors are the most influential participants in currency markets.
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). This highlights the dominant role of financial investment flows in driving exchange rate dynamics, including the uk sterling to euro exchange rate.
Additionally, the UK’s persistent trade deficit, where imports consistently exceed exports, leads to a current account deficit. This deficit increases the UK’s reliance on international capital inflows and makes the pound more susceptible to the movements of global capital. The current account deficit has been increasingly financed by these capital inflows, further emphasizing the pound’s vulnerability to shifts in investor sentiment and capital flows that impact the uk sterling to euro exchange rate.
Brexit’s Impact on Sterling’s Attractiveness
The behavior of financial institutions in currency markets is primarily driven by factors that influence the perceived return on investments in different currencies. Therefore, the depreciation of uk sterling to euro following the Brexit vote indicates that financial market participants believed that investments in assets denominated in pounds would perform less favorably after Brexit than they would have otherwise.
Numerous factors can influence returns in currency markets, and isolating the specific impact of each factor is complex. However, key drivers typically include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations.
Interest Rates and the Sterling-Euro Rate
Changes in interest rates, or factors that are expected to influence future interest rates, are considered primary drivers of exchange rates, including the uk sterling to euro rate. This is because domestic interest rates can affect the relative attractiveness of assets in different countries. A decrease in interest rates in a country makes assets linked to that rate less appealing due to the lower return they offer. An unexpected reduction in interest rates, assuming other factors remain constant, will lead to a decrease in demand for those assets relative to equivalent assets in currencies with higher interest rates. This, in turn, causes a depreciation in the value of the currency in question.
For example, 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 program of ‘quantitative easing’ (QE). However, it’s important to note that this policy change was announced weeks after the Brexit vote. Therefore, the immediate and substantial fall in uk sterling to euro in June 2016, and subsequent declines in later years, cannot be solely attributed to the financial market’s reaction to this specific interest rate policy change.
Uncertainty, Political Instability, and Risk Perception
Changes in perceived risk also significantly impact expected returns and influence investor decisions about asset holdings, including currency choices like uk sterling to euro. Increased uncertainty regarding factors such as future company performance, the overall economic outlook, interest rate trajectories, and political stability can make holding assets in a particular currency riskier. This heightened risk perception can reduce or delay investment inflows.
The increased probability of greater trade frictions between the UK and the EU post-Brexit amplified these risks for assets denominated in pounds. Research conducted prior to the referendum predicted substantial decreases in foreign investment in the UK as a consequence of Brexit-related trade costs.
These risks were further compounded by significant and persistent political instability in the UK. This prolonged and deepened the uncertainty surrounding post-Brexit trading relationships and the likely economic outcomes. The most substantial and sustained declines in uk sterling to euro since 2016 were closely linked to periods of heightened uncertainty and associated political turmoil.
One of the most significant drops 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. A no-deal Brexit was widely considered to be the worst-case economic scenario for the UK.
Evidence suggests that the negative impacts of this uncertainty on employment, productivity, and investment in UK businesses became increasingly apparent in the years immediately following the referendum.
Alt text: Boris Johnson becomes Prime Minister and its potential impact on UK Sterling to Euro exchange rate. Image of Boris Johnson assuming office, symbolizing political uncertainty and its correlation with fluctuations in the pound to euro rate.
Investor Expectations and Market Sentiment
The depreciation of uk sterling to euro largely predates the actual implementation of Brexit. Conversely, exchange rate movements were relatively subdued when the UK officially left the EU and the transition period concluded at the end of 2020. This timing highlights the critical 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 affects expectations about a currency’s future prospects will quickly be reflected in its exchange rate, including the uk sterling to euro rate. If market participants anticipate a negative future impact on investments in a currency, they will sell that currency, causing its value to fall.
The record fall in the pound immediately after the referendum exemplifies the rapid impact of shifting market expectations on currencies. The Leave vote surprised many commentators, as last-minute polls suggested a likely Remain victory, which had initially caused sterling to appreciate in the days leading up to the referendum. The subsequent collapse in the pound’s value immediately after the result underscores the negative expectations that financial market participants held regarding sterling investments once the outcome was clear.
The significant drops in uk sterling to euro in 2017 and 2019, during periods of heightened political uncertainty, also reflect increasingly negative expectations for sterling-denominated investments. These negative expectations were driven by the growing probability of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade agreement were associated with increases in the pound’s value against the euro.
Recent research has established specific links between economic policy uncertainty and exchange rate expectations. These findings suggest that market participants factor in the level of policy uncertainty when forming their expectations about currency values and exchange rates like uk sterling to euro.
Consequences of Sterling’s Depreciation
One immediate consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK residents. This directly contributes to higher inflation rates and an increased cost of living for UK citizens. Essentially, a weaker uk sterling to euro exchange rate means that goods and services priced in euros become more expensive for UK consumers.
However, a weaker currency can also offer potential benefits. It can make exports more competitive by reducing the cost of domestic goods and services for buyers in other countries, including the Eurozone. This could potentially improve the UK’s trade deficit and contribute to 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 unclear. To fully understand the longer-term consequences of the Brexit-related fall in uk sterling to euro and the pound’s value in general, further research and analysis are necessary.
Experts on Exchange Rates and Brexit Impacts:
- 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)
Author: Christopher Coyle
