GBP vs Euro: Decoding the Dynamics of the Pound Euro Exchange Rate Post-Brexit
At the beginning of 2021, the British pound (GBP) stood significantly weaker against the euro (EUR) compared to its position before the 2016 Brexit referendum. Specifically, the pound was approximately 15% lower against the euro than it was in June 2016, prior to the vote on the UK’s membership in the European Union (EU). This depreciation was even more pronounced when compared to December 2015, when the EU Referendum Act received Royal Assent, with Sterling being 20% weaker.
Brexit has emerged as a dominant factor influencing the volatility of the GBP/EUR exchange rate over the past five years. The immediate aftermath of the referendum vote saw the pound experience its most dramatic 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 the pound to new lows against both the euro and the US dollar by August 2019. These movements underscore the profound impact of Brexit on the GBP vs EUR currency pair.
This depreciation largely stemmed from growing expectations of increased trade barriers between the UK and the EU, its largest trading partner. Coupled with heightened uncertainty and persistent political instability, these factors led financial institutions to reduce their holdings of pound-denominated assets. As institutions sold off Sterling assets, the demand for the pound decreased, driving down its value relative to other currencies, including the euro.
An exchange rate reflects the price of one currency in relation to another, fluctuating based on supply and demand dynamics. In the case of GBP vs EUR, the post-referendum decline in the pound’s value indicates a decrease in demand for holding pounds compared to euros. Understanding the fundamental drivers behind these Brexit-related exchange rate shifts requires examining the factors that influence currency demand.
While international trade in goods and services plays a role in currency markets, the significant and rapid falls in the value of the pound since 2016 occurred before any actual changes in the UK-EU trading relationship took effect. Moreover, the volume of trade in goods and services is not the primary driver of foreign exchange transactions and tends to be relatively stable in the short term. This suggests that factors beyond trade in goods and services were primarily responsible for the extreme fluctuations in the GBP/EUR exchange rate associated with Brexit.
A critical factor behind the sharp declines in the pound’s value against the euro and other currencies has been a significant decrease in the preference of financial institutions to hold investments denominated in pounds. Currency trading for investment purposes, or financial asset trading, constitutes the largest share of currency transactions and is typically the most significant driver of exchange rate movements, especially in the short run.
This type of capital movement is often referred to as ‘hot money’ – highly mobile capital that can be rapidly shifted between investments or currencies, exerting a swift and substantial impact on exchange rates. Consequently, major players in currency markets are financial institutions such as banks, securities firms, and institutional investors. These institutions prioritize factors affecting investment returns in different currencies, making them key drivers of shifts in the GBP/EUR exchange rate.
The persistent current account deficit in the UK, where imports consistently exceed exports, further exacerbates the pound’s vulnerability to international capital flows. This deficit increases reliance on external financing, making the pound more susceptible to movements of international capital and the sentiments of financial markets regarding GBP vs EUR.
The decline in the value of sterling following the Brexit vote implies that financial market participants anticipated poorer performance for pound-denominated investments compared to euro-denominated investments. Several factors can influence returns in currency markets, with changes in relative interest rates, perceived risk, and overall investor expectations being particularly important in the GBP vs EUR context.
Changes in interest rates are considered a primary driver of exchange rates, including GBP/EUR. Domestic interest rates affect the relative return on assets in different countries. A decrease in UK interest rates, for instance, makes pound-linked assets less attractive compared to euro-linked assets, leading to reduced demand for the pound and a subsequent depreciation against the euro. While the Bank of England did reduce interest rates after the Brexit vote, the immediate and substantial fall in the pound predates this policy change, suggesting other factors were at play in the initial GBP/EUR movement.
Increased uncertainty and political instability significantly amplify risk, influencing investor decisions about currency holdings. Uncertainty surrounding future economic performance, trade relationships, and political stability makes holding assets in a specific currency, like the pound, riskier, potentially reducing investment inflows and weakening the GBP relative to the EUR. The heightened likelihood of increased trade frictions between the UK and the EU post-Brexit significantly amplified these risks for pound-denominated assets, directly impacting the GBP vs EUR exchange rate.
The most substantial and sustained falls in the pound since 2016 have been closely linked to periods of heightened uncertainty and political turmoil. For example, one of the largest drops in sterling against the euro occurred in 2017 following an early general election that resulted in a hung parliament, increasing uncertainty about the future political direction and its impact on the economy and GBP/EUR. Similarly, in 2019, the pound fell to multi-year lows against both the dollar and the euro amidst rising concerns over a ‘no-deal’ Brexit, highlighting the sensitivity of the GBP vs EUR exchange rate to Brexit-related political and economic uncertainties.
Investor expectations are a crucial trigger for currency movements, particularly in the highly reactive GBP/EUR market. Changes in expectations are rapidly incorporated into currency valuations due to the sheer volume and speed of trading. Negative expectations regarding the future performance of pound-denominated investments lead to selling pressure on the pound, causing it to depreciate against the euro.
The record fall in the pound immediately after the referendum exemplifies the powerful impact of shifting market expectations. The initial appreciation of sterling based on pre-referendum polls suggesting a Remain victory, followed by a sharp collapse upon the Leave result, underscores the critical role of expectations in driving GBP/EUR fluctuations. Subsequent falls in 2017 and 2019, driven by increasing political uncertainty and the rising probability of a ‘hard’ Brexit, further reinforce the influence of expectations on the pound euro exchange rate.
A direct consequence of a weaker pound against the euro is that goods, services, and assets from the Eurozone become more expensive for UK residents. This contributes to higher inflation in the UK and an increased cost of living. Conversely, a weaker pound can make UK exports more competitive in Eurozone markets by reducing the cost of UK goods and services for European buyers. This can potentially improve the UK’s trade balance with the Eurozone and stimulate economic growth. However, the overall impact of pound depreciation, particularly in the context of Brexit and evolving trade relationships with the EU, remains complex and requires further analysis to fully understand the long-term consequences for the UK economy and the GBP vs EUR exchange rate.
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Who are experts on this question?
- 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
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