At the beginning of 2021, the British Pound (GBP), often referred to as UKP, was approximately 15% weaker against the Euro (EUR) compared to its position on the eve of the UK’s European Union (EU) membership referendum in June 2016. This devaluation is even more stark when considering that Sterling was 20% weaker than its value when the EU Referendum Act was enacted in December 2015.
Over the past half-decade, Brexit has emerged as a dominant factor influencing the volatility of exchange rates, significantly impacting the value of the pound sterling relative to other major global currencies, especially the euro. The immediate aftermath of the 2016 referendum vividly demonstrated this effect, with Sterling experiencing its most dramatic single-day fall in three decades. This initial shock was followed by two more substantial and sustained declines in 2017 and 2019, pushing the value of sterling 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 the anticipation of increased trade barriers between the UK and its largest trading partner, coupled with heightened uncertainty and persistent political instability. These factors prompted financial institutions to reduce their holdings of the pound. As organizations increasingly divested from sterling-denominated assets, the pound’s value decreased in comparison to other currencies, notably the euro.
Understanding Exchange Rate Fluctuations
An exchange rate represents the price of one currency in relation to another. Its fluctuations are governed by the principles of supply and demand. In any currency pair, one currency will appreciate (increase in value) while the other will depreciate (decrease in value) based on market dynamics: increased demand for the former and increased selling pressure on the latter.
Fundamentally, the decline in the value of sterling since the Brexit referendum indicates a decrease in the demand to hold pounds compared to other currencies, particularly the euro. To fully grasp the underlying causes of these Brexit-related exchange rate shifts, it’s crucial to identify the factors that influence the demand for a specific currency.
Key Players in Exchange Rate Dynamics
Entities engaged in international trade of goods and services are significant participants in currency markets. This includes multinational corporations involved in cross-border commerce and individual travelers exchanging currency for personal spending. For instance, when a UK entity or resident purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars relative to pounds. Significant shifts in international trade flows can, therefore, alter the demand for and value of a currency.
However, the sharp and rapid declines in the value of sterling observed since 2016 occurred before any actual changes in the trading relationship between the UK and the EU took effect. Furthermore, the volume of trade in goods and services is not the primary driver of overall foreign exchange transactions and typically does not fluctuate dramatically in the short term (Bank for International Settlements, BIS, 2019). This suggests that changes in the trade of goods and services are not the primary cause of extreme exchange rate volatility and may not be the main reason for the Brexit-related depreciation of the pound against the euro.
A critical factor behind the significant falls in the pound’s value since 2016 is the substantial reduction in the preference of financial institutions to hold investments denominated in pounds. Trading currencies for investment purposes, or trading in financial assets, constitutes the largest proportion of currency transactions and is typically the most significant driver of exchange rate changes, especially in the short run.
This is often referred to as ‘hot money’ – capital that is highly mobile and can be rapidly shifted between investments or currencies on a large scale, causing swift impacts on exchange rates. Consequently, the dominant and most influential players 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).
Moreover, with the UK’s persistent trade deficit where imports exceed exports, the resulting current account deficit increases reliance on external financing, making the pound more susceptible to international capital flows. This vulnerability arises because the current account deficit has become increasingly reliant on these capital inflows for funding.
Brexit’s Impact on the Pound’s Appeal
The primary factors that influence financial institutions’ decisions in currency markets are those that affect the returns on investments in different currencies. Consequently, the Brexit-related depreciation of sterling suggests that financial market participants anticipated that investments in pound-denominated assets would perform less favorably after the Brexit vote than they would have otherwise.
Various factors can potentially influence returns in currency markets, and isolating the individual effects is complex. However, some of the most critical factors are typically shifts in relative interest rates, changes in perceived risk, and alterations in overall investor expectations.
Interest Rates
Changes in interest rates, or factors influencing interest rates, are considered primary drivers of exchange rates. This is because domestic interest rates can affect the relative attractiveness of assets in different countries. A decrease in a country’s interest rates means that assets linked to that rate will yield a lower return. An unexpected reduction in interest rates (assuming other factors remain constant) will lead to a decreased demand for those assets compared to equivalent assets in other currencies, resulting in a depreciation of the currency in question.
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. It’s important to note that this policy adjustment was announced weeks after the Brexit vote. Therefore, the substantial fall in the pound’s value in June 2016, or in subsequent years, cannot be directly attributed to financial market participants’ immediate reaction to this specific interest rate change.
Uncertainty and Political Instability
Changes in risk perceptions can also significantly impact expected returns and influence investors’ decisions regarding asset holdings, including currencies. Increased uncertainty surrounding factors such as future company performance, economic outlook, interest rates, and political stability can make holding assets in a particular currency riskier, leading to reduced or delayed investment inflows (Pindyck, 1991).
The heightened probability of increased trade frictions between the UK and the EU post-Brexit amplified these risks for pound-denominated assets. Research conducted before the referendum 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 within the UK, which prolonged and deepened uncertainty regarding post-Brexit trading relationships and the anticipated economic consequences. The most significant and sustained depreciations of the pound since 2016 were closely linked to increased uncertainty and associated political turmoil.
One of the most pronounced declines 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 the possibility of a ‘no-deal’ Brexit – widely considered the worst-case economic scenario for the UK.
Evidence suggests that the negative repercussions 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).
Investor Expectations
The depreciation of sterling predominantly occurred before Brexit formally took place. In contrast, exchange rate movements were relatively muted when the UK officially left the EU and the transition period concluded at the end of 2020. This timing is explained by the significant 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 massive volume and speed of trading. Any new information that affects expectations about a currency’s future prospects will quickly be reflected in exchange rates. If market participants anticipate a negative future impact on investments in a currency, they will sell that currency, causing its value to decline.
The record fall of the pound after the referendum illustrates the rapid impact of shifting market expectations on currencies, as the Leave vote surprised many analysts. 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 immediately after the result underscores the negative expectations that financial market participants developed for sterling investments once the outcome became clear.
The significant falls in the pound in 2017 and 2019, during periods of heightened political uncertainty, also reflect increasingly pessimistic expectations for sterling-denominated investments driven by the growing likelihood of a ‘hard’ Brexit. Conversely, increased optimism about an orderly Brexit and a trade agreement preceded increases in the pound’s value.
Recent research has highlighted specific links between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). These findings suggest that market participants factor in the level of policy uncertainty when forming their expectations about currency values.
Consequences of Sterling’s Depreciation
A direct consequence of a weaker pound is that imported goods, services, and assets become more expensive for UK residents. This leads to increased inflation and a higher cost of living.
However, a weaker currency can also offer benefits by making exports more competitive. It reduces the cost of domestic goods and services for residents of other countries, potentially leading to positive effects on 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 outcome for the UK economy even more ambiguous. Further research is necessary to fully understand the long-term consequences of the Brexit-related fall in sterling against the euro and other currencies.
Further Resources
For deeper insights into this topic, consider exploring resources from institutions specializing in economics and finance.
Experts in the Field
- 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
