Euro Sterling Exchange Rate: Understanding Brexit’s Impact and Future Trends

Since the beginning of 2021, the British pound has experienced a significant weakening against the euro. This depreciation is approximately 15% compared to the pre-Brexit referendum levels of June 2016. Furthermore, when measured against the value of sterling when the EU Referendum Act received Royal Assent in December 2015, the pound is down by 20%. This substantial shift highlights the profound impact of Brexit on the Euro Sterling exchange rate.

Over the past half-decade, Brexit has emerged as a dominant factor influencing the volatility and overall value of the pound relative to major currencies, notably the euro. The immediate aftermath of the 2016 referendum witnessed the most dramatic illustration of this impact, with sterling enduring its most significant single-day drop in three decades. This initial shock was followed by further 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 depicted in Figure 1.

This downward pressure on the pound largely stemmed from growing expectations of increased trade barriers between the UK and the European Union, its largest trading partner. Coupled with escalating uncertainty and persistent political instability, these factors prompted financial institutions to reduce their holdings of sterling. As a greater number of organizations divested from assets denominated in pounds, the currency’s value decreased relative to the euro and other currencies.

The Mechanics of Exchange Rate Fluctuations

An exchange rate fundamentally represents the price of one currency in relation to another. These rates are dynamic, governed by the principles of supply and demand. In any currency pair, one currency will appreciate (increase in value) while the other depreciates (decrease in value) based on market activity – increased buying of one currency and selling of the other.

In essence, the depreciation of sterling since the Brexit referendum reflects a reduced demand for holding pounds compared to other currencies, particularly the euro. Therefore, to fully grasp the underlying causes of Brexit-related movements in the euro sterling exchange rate, it’s crucial to understand the factors that drive currency demand.

Key Players in Exchange Rate Dynamics

Participants in international trade, dealing in goods and services, are essential and familiar actors within currency markets. This includes businesses engaged in cross-border sales and individual travelers exchanging currency for personal expenses. For instance, when a UK entity or individual purchases goods from the United States, they must convert pounds into dollars, thereby increasing the demand for dollars. Significant shifts in international trade flows of goods and services can, therefore, alter the demand for and value of a currency, impacting the euro sterling rate indirectly through broader market movements.

However, the rapid and significant depreciation of sterling following 2016 occurred prior to any actual changes in the trade relationship between the UK and the EU. Furthermore, the volume of trade in goods and services is not the primary driver of overall foreign exchange transactions, and it tends to exhibit limited short-term volatility (Bank for International Settlements, BIS, 2019). This suggests that fluctuations in goods and services trade are not the primary cause of extreme exchange rate volatility and may not be the main reason for the Brexit-related decline in the euro sterling exchange rate.

A critical factor contributing to the sharp declines in the pound’s value against the euro since 2016 is a substantial 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 portion of currency transactions and is typically the most significant driver of exchange rate changes, especially in the short term. This is particularly relevant to the euro sterling exchange rate, as investment flows can rapidly shift between these major currencies.

This investment-driven currency movement is often referred to as ‘hot money’ – capital that is highly mobile and can swiftly move between different investments or currencies on a large scale, causing rapid shifts in exchange rates, including euro sterling. Consequently, the most influential participants in currency markets are financial institutions such as banks, securities firms, and institutional investors, all of whom actively trade the euro sterling pair.

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). This highlights the dominance of financial institutions in driving euro sterling exchange rate movements.

Moreover, the UK’s persistent trade deficit, where imports consistently exceed exports, leads to a reliance on external financing, often described as the ‘kindness of strangers’. This reliance makes the pound, and consequently the euro sterling rate, more susceptible to fluctuations in international capital flows, as the current account deficit has been increasingly financed by these inflows.

Brexit’s Diminishing Appeal of the Pound

The primary factors that financial institutions consider in currency markets are those that influence the return on investments in different currencies. Therefore, the Brexit-related depreciation of sterling against the euro suggests that financial market participants anticipated that investments in pound-denominated assets would perform less favorably following the Brexit vote than they would have otherwise. This directly impacts the euro sterling exchange rate as investors adjust their portfolios.

Numerous factors can potentially influence returns in currency markets, and isolating the individual effects is complex. However, some of the most significant factors typically include changes in relative interest rates, shifts in perceived risk, and alterations in overall investor expectations, all of which are relevant to the euro sterling dynamic post-Brexit.

Interest Rates

Changes in interest rates, or factors influencing them, are widely recognized as primary drivers of exchange rates, including euro sterling. This is because domestic interest rates can affect the relative attractiveness of assets in different countries. A reduction in interest rates within a country diminishes the return on assets linked to that rate. An unexpected decrease in interest rates (assuming other factors remain constant) leads to a reduced demand for those assets compared to equivalent assets in other currencies, such as the euro. This, in turn, causes a depreciation in the value of the currency in question, impacting the euro sterling exchange rate.

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 programme 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 the euro sterling rate in June 2016, or in subsequent years, cannot be solely attributed to the financial market reaction to this specific interest rate adjustment.

Uncertainty and Political Instability

Changes in risk perception also significantly affect expected returns and influence investor decisions regarding asset holdings, including currencies like euro sterling. Increased uncertainty surrounding factors such as future corporate performance, economic forecasts, interest rate trajectories, and political stability can make holding assets in a specific currency riskier. This heightened risk reduces or delays investment inflows (Pindyck, 1991), negatively impacting the euro sterling exchange rate.

The high probability of increased trade frictions between the UK and the EU post-Brexit amplified these risks for assets denominated in pounds. Research conducted prior to the referendum anticipated 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 ongoing political instability within the UK, which prolonged and deepened uncertainty surrounding post-Brexit trade relationships and the anticipated economic outcomes. The most pronounced and persistent depreciations of the pound against the euro since 2016 have been closely correlated with periods of heightened uncertainty and associated political turmoil.

One of the most significant drops in sterling’s value relative to 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 within days of Boris Johnson assuming office as prime minister and his refusal to rule out a ‘no-deal’ Brexit – widely considered to be the most adverse economic scenario for the UK, and consequently for the euro sterling rate.

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), further impacting the euro sterling exchange rate.

Expectations

The depreciation of sterling against the euro and other currencies largely occurred before Brexit officially took place. Conversely, 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 play a crucial role in triggering currency movements (Dornbusch, 1976; Engle and West, 2005). These expectations are particularly sensitive in the euro sterling market due to the close economic ties between the UK and Eurozone.

Changes in investor expectations are rapidly incorporated into currency markets due to the sheer volume and speed of trading. Any new information that influences expectations regarding a currency, such as euro sterling, 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-breaking 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, 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 held for sterling investments, and consequently the euro sterling exchange rate, once the outcome became clear.

The significant depreciations of the pound against the euro 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 optimism regarding an orderly Brexit and a trade agreement preceded increases in the pound’s value, showing the direct link between expectations and the euro sterling rate.

Recent research has established specific connections between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). Findings indicate that market participants consider the level of policy uncertainty when forming their expectations, directly influencing the euro sterling exchange rate.

Economic Consequences of Sterling’s Depreciation

One immediate consequence of a weaker sterling, particularly against the euro, is that goods, services, and assets originating from countries using the euro become more expensive for UK residents. This directly contributes to higher inflation levels and an increased cost of living for UK citizens due to higher import prices from the Eurozone.

However, a weaker currency can also offer potential benefits. It can make exports more competitive by reducing the cost of domestically produced goods and services for residents of other countries, including those in the Eurozone. This could potentially have positive effects on the UK’s trade deficit and overall economic growth, although the net impact on the euro sterling relationship is complex.

Research on the overall balance of these effects following a currency depreciation, including euro sterling, is inconclusive. Furthermore, ongoing uncertainty surrounding the extent and implications of post-Brexit trade frictions makes the long-term economic outcome for the UK, and consequently the euro sterling exchange rate, even more uncertain. Further research is necessary to fully understand the longer-term consequences of the Brexit-related depreciation of sterling against the euro.

Further Resources and Expert Insights

For those seeking deeper insights into this topic, further resources and expert perspectives are available.

Leading Experts on Euro Sterling and Exchange Rates

• 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)