Understanding the Currency Exchange Rate: Euro to Pound Sterling and Brexit’s Impact
The currency exchange rate between the euro and the pound sterling is a critical indicator in the global financial market, reflecting the relative economic strengths and geopolitical factors influencing these major currencies. Since the 2016 Brexit referendum, the euro to pound sterling exchange rate has experienced significant volatility, largely driven by the evolving economic and political landscape surrounding the UK’s departure from the European Union.
At the beginning of 2021, the pound sterling was approximately 15% weaker against the euro compared to its position on the eve of the Brexit referendum in June 2016. This devaluation is even more pronounced when considering the period before the referendum process formally began; the pound was 20% weaker than when the EU Referendum Act received Royal Assent in December 2015. This dramatic shift highlights the profound impact of Brexit on the perceived value of the pound in currency markets.
Brexit has undeniably been a central factor in the fluctuations of the euro to pound sterling exchange rate over the past half-decade. The immediate aftermath of the referendum vote witnessed the pound sterling’s most significant single-day drop in 30 years. This initial shock was followed by further substantial and sustained declines in 2017 and 2019. By August 2019, the value of the pound reached new lows against both the euro and the US dollar, illustrating a consistent downward trend influenced by Brexit uncertainties.
This consistent weakening of the pound against the euro and other major currencies stemmed primarily from growing expectations of increased trade barriers between the UK and the EU, its largest trading partner. The uncertainty surrounding the future economic relationship, coupled with persistent political instability in the UK, prompted financial institutions to reduce their holdings of pound sterling assets. As major financial players divested from sterling, the supply of the pound in the currency market increased, driving down its value relative to the euro and other currencies. This illustrates how market sentiment and anticipation of future economic conditions heavily influence currency exchange rate dynamics.
The Mechanics of Exchange Rate Movements
An exchange rate, such as the euro to pound sterling rate, is essentially the price of one currency in relation to another. Like any price in a market economy, it is determined by the forces of supply and demand. When demand for the euro increases relative to the pound sterling, the euro appreciates in value against the pound, and conversely, the pound depreciates against the euro. This dynamic interplay of currency demand dictates the fluctuations observed in the euro to pound sterling exchange rate.
The depreciation of the pound sterling since the Brexit referendum signifies a decrease in the global demand to hold pounds relative to other currencies, particularly the euro. To fully grasp the underlying reasons for these Brexit-related exchange rate movements, it’s crucial to understand the factors that drive demand for a currency in the international market.
Key Players in the Currency Exchange Market
While businesses engaged in international trade and individual travelers exchanging currency are participants in the foreign exchange market, their impact on major currency exchange rates like euro to pound sterling is often overshadowed by larger institutional forces. Companies involved in importing and exporting goods and services, as well as tourists, do contribute to currency demand. For instance, when a UK company imports goods from a Eurozone country, it needs to convert pounds into euros, increasing the demand for euros and potentially influencing the euro to pound sterling exchange rate.
However, the rapid and substantial depreciation of the pound since 2016 occurred before any significant changes in the actual trading relationship between the UK and the EU were implemented. Furthermore, trade in goods and services, while important, does not represent the primary volume of foreign exchange transactions, particularly in the short term. This suggests that factors beyond simple trade flows are the main drivers of the extreme volatility witnessed in the euro to pound sterling exchange rate.
A critical factor behind the sharp falls in the pound sterling’s value against the euro is the significant reduction in the preference of financial institutions to hold investments denominated in pounds. The trading of currencies for investment purposes, often referred to as trade in financial assets, constitutes the majority of currency transactions and is typically the most significant driver of exchange rate fluctuations, especially in the short to medium term. This is particularly true for a major currency pair like the euro to pound sterling.
This investment-driven currency movement is often termed ‘hot money’ – capital that is highly mobile and can move between investments and currencies swiftly and on a large scale. This rapid movement of capital can exert significant pressure on exchange rates. Consequently, the most influential participants in the euro to pound sterling exchange rate market are financial institutions, including banks, investment firms, and institutional investors.
Data from 2019 reveals that financial institutions (excluding foreign exchange dealers) accounted for 57.8% of foreign exchange turnover in the UK, while non-financial customers directly contributed to only 4.9% of the volume. This underscores the dominant role of financial investment flows in driving currency exchange rate movements, including the euro to pound sterling rate.
Furthermore, the UK’s persistent trade deficit, where imports consistently exceed exports, creates a reliance on international capital inflows to finance this deficit. This dependence makes the pound sterling more vulnerable to shifts in global investment sentiment and capital flows, further impacting the euro to pound sterling exchange rate.
Brexit’s Impact on Pound Sterling’s Attractiveness
Financial institutions, the primary drivers in currency markets, react primarily to factors that influence the returns on investments denominated in different currencies. The depreciation of the pound sterling following the Brexit vote indicates that financial market participants believed that investments in pound-denominated assets would perform less favorably post-Brexit. This perception directly impacted the euro to pound sterling exchange rate as investors shifted away from the pound.
Several factors can affect investment returns in currency markets, and isolating the individual effects can be complex. However, key determinants typically include changes in relative interest rates, shifts in perceived risk, and evolving investor expectations. These elements have all played a role in shaping the euro to pound sterling exchange rate post-Brexit.
Interest Rates and the Euro to Pound Sterling Rate
Changes in interest rates are a primary driver of exchange rates like euro to pound sterling. Domestic interest rates influence the relative attractiveness of assets in different countries. A decrease in interest rates in the UK makes pound-denominated assets less appealing compared to euro-denominated assets, assuming Eurozone interest rates remain relatively stable. An unexpected reduction in UK interest rates, all else being equal, leads to decreased demand for pound sterling assets, causing the pound to depreciate against the euro.
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 program. However, this policy change occurred weeks after the initial Brexit vote. Therefore, while interest rate adjustments play a role, the immediate and significant fall in the pound sterling’s value in June 2016 cannot be solely attributed to this specific interest rate cut. The initial shock was more about anticipated future economic conditions.
Uncertainty, Political Instability and the Currency Market
Changes in perceived risk also significantly impact expected returns and influence investor decisions regarding currency holdings. Increased uncertainty surrounding factors such as future economic performance, interest rate trajectories, and political stability elevates the risk associated with holding assets in a specific currency. This increased risk can lead to reduced investment flows, negatively impacting the currency’s value. The euro to pound sterling exchange rate is particularly sensitive to these risk perceptions.
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 substantial declines in foreign investment in the UK due to Brexit-related trade costs. This anticipation of economic disruption contributed to the pound’s weakening against the euro.
These risks were further exacerbated by significant and persistent political instability in the UK, which prolonged and deepened uncertainty about post-Brexit trading relationships and the overall economic outlook. The most substantial and sustained drops in the pound sterling’s value against the euro 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 following an early general election that resulted in a hung parliament. Similarly, in 2019, the pound fell to multi-year lows against both the dollar and the euro shortly after Boris Johnson became Prime Minister, particularly due to concerns about a potential ‘no-deal’ Brexit, widely considered the worst-case economic scenario for the UK. These events clearly demonstrate the strong link between political uncertainty and the euro to pound sterling exchange 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. This further reinforced negative sentiment towards pound-denominated assets, influencing the euro to pound sterling exchange rate.
The Power of Expectations in Currency Valuation
Interestingly, the most significant depreciation of the pound sterling occurred before Brexit actually materialized. In contrast, currency exchange rate movements were relatively muted when the UK formally left the EU and the transition period concluded at the end of 2020. This highlights the crucial role of investor expectations in shaping currency movements.
Changes in investor expectations are rapidly incorporated into currency markets due to the sheer volume and speed of trading. Any new information that affects expectations about a currency’s future performance is quickly reflected in its exchange rate. If market participants anticipate negative future implications for investments in a particular currency, they will sell that currency, causing its value to decline. This anticipatory behavior is a key driver of the euro to pound sterling exchange rate.
The record fall of the pound after the referendum exemplifies the immediate impact of shifting market expectations on currencies. The Leave vote surprised many, as last-minute polls suggested a Remain victory, initially causing the pound to appreciate slightly. The subsequent collapse in the pound’s value immediately after the referendum result underscores the negative expectations that financial market participants held regarding sterling investments once the outcome became clear. Similarly, the significant falls in the pound in 2017 and 2019 coincided with periods of increased political uncertainty, reflecting growing negative expectations for pound-denominated investments due to the rising probability of a ‘hard’ Brexit. Conversely, improved prospects of an orderly Brexit and a trade agreement led to increases in the pound’s value against the euro and other currencies.
Research confirms the direct link between economic policy uncertainty and exchange rate expectations. Market participants factor in the level of policy uncertainty when forming their expectations, which in turn influences currency valuations and the euro to pound sterling exchange rate.
Consequences of a Weaker Pound Sterling
One immediate consequence of a weaker pound sterling is that goods, services, and assets from Eurozone countries and other foreign nations become more expensive for UK residents. This directly contributes to higher inflation rates and an increased cost of living for UK households. For example, imported goods from the Eurozone become pricier in pound terms, raising the overall price level in the UK.
However, a weaker currency can also offer benefits. It can enhance the competitiveness of UK exports by making domestic goods and services cheaper for buyers in Eurozone countries and other international markets. This potential boost to exports could, in theory, positively impact the UK’s trade deficit and contribute to overall economic growth.
Nevertheless, research on the net effect of currency depreciation, like the pound sterling’s decline against the euro, is inconclusive. Furthermore, the ongoing uncertainty surrounding the extent and implications of post-Brexit trade frictions makes the long-term economic consequences for the UK even more uncertain. Understanding the longer-term ramifications of the Brexit-related depreciation of the pound sterling against the euro requires further in-depth research and analysis.