Since the Brexit vote in 2016, the exchange rate of the pound against other leading currencies has fallen significantly. This seems to reflect a generally negative outlook among international investors for the UK’s economic prospects outside the European Union.
At the start of 2021, the pound was approximately 15% weaker relative to the euro than it was on the eve of the referendum on the UK’s membership of the European Union (EU) in June 2016. Sterling was also 20% weaker than it was when the EU Referendum Act received Royal Assent in December 2015.
Over the last five years, Brexit has been one of the key factors influencing exchange rate volatility and the value of the pound against other leading currencies. The effect of Brexit was particularly evident immediately after the referendum result, as sterling experienced its largest fall within a single day in 30 years. There were two further substantial and sustained falls in 2017 and 2019, bringing the value of sterling to new lows against the euro and the dollar in August 2019 – see Figure 1.
This largely happened because expectations of increased trade frictions between the UK and its largest trade partner, as well as increased uncertainty and persistent political instability, led financial institutions to sell the pound. As more and more organisations sold sterling-denominated assets, the value of the pound was driven down relative to other currencies.
Figure 1: Pound/Euro daily exchange rate 2015-2021
Source: Bloomberg
Why do exchange rates change?
An exchange rate is simply the price of one currency relative to another. It will change with the laws of supply and demand. This means that one currency in an exchange rate pair will go up (appreciate) and the other will go down (depreciate) when people buy more of the former and sell the latter.
At the most basic level, the fall in the value of sterling since the referendum means that there has been a fall in demand to hold the pound relative to other currencies. Therefore, to understand the fundamental reasons behind Brexit-related exchange rate movements, we need to identify the factors that affect the demand for a currency.
Who drives exchange rate changes?
Organisations involved in the international trade of goods and services are familiar and important participants in currency markets. This includes companies selling goods and services across borders as well as individual travellers changing money for personal use. For example, when a UK resident or company buys goods in the United States, they must convert pounds into dollars, increasing the relative demand for dollars. Large changes in the international trade of goods and services can therefore alter the demand for and value of a currency.
But the rapid and substantial falls in the value of sterling since 2016 occurred before any changes in the trading relationship between the UK and EU had actually taken place. What’s more, trade in goods and services is not the primary source of overall foreign exchange transactions and does not tend to change sharply in the very short run (Bank for International Settlements, BIS, 2019). This suggests that changes in the trade of goods and services are not the primary driver of the extreme fluctuations in exchange rates and may not have been the main reason for the fall in the value of sterling associated with Brexit.
A crucial cause of the sharp falls in the value of the pound since 2016 is the substantial decrease in the preference of financial institutions to hold investments denominated in pounds. The trade of currencies for investment purposes, or trade in financial assets, makes up the largest proportion of currency transactions and is typically the largest driver of exchange rate changes, particularly in the short run.
This is sometimes known as ‘hot money’ – money that is very mobile and can move between investments or currencies quickly and at great scale, rapidly affecting exchange rates. Consequently, the largest and most influential participants in currency markets are financial institutions such as banks, securities firms and institutional investors.
In 2019, financial institutions (excluding foreign exchange dealers) were responsible for 57.8% of foreign exchange turnover in the UK. Just 4.9% of currency exchange volume was directly attributable to non-financial customers (BIS, 2019).
In addition, as imports are persistently greater than exports in the UK, the resulting current account deficit increases reliance on the ‘kindness of strangers’ and makes the pound more vulnerable to the movements of international capital. This is because the current account deficit has been increasingly funded by these capital inflows.
Why did Brexit make the pound less attractive?
The primary factors to which financial institutions respond in currency markets are those that influence the return on investments in different currencies. As a result, the fall in the value of sterling associated with Brexit suggests that participants in financial markets believed that investments in assets denominated in pounds would perform worse following the vote for Brexit than they otherwise would have.
A number of factors can potentially affect returns in currency markets, and disentangling the individual effects is difficult. Even so, some of the most important factors are typically changes in relative interest rates, changes in risk and changes in the overall expectations of investors.
Interest rates
Changes in interest rates (or factors that affect interest rates) are seen as a primary driver of exchange rates. This is because domestic interest rates can affect the relative return on assets in different countries. A reduction in interest rates in a country means that assets linked to that rate will earn a lower return. An unexpected decrease in interest rates (with other factors constant) will lead to a fall in demand for those assets, relative to equivalent assets in other currencies. This will cause a fall in the value of the currency in question.
For example, in response to the Leave vote, the Bank of England reduced interest rates in August 2016 from 0.5% to 0.25% and increased its programme of ‘quantitative easing’ (QE). It should be noted, however, that this policy change was announced weeks after the Brexit vote took place. The large fall in the value of the pound in June 2016, or in subsequent years, cannot therefore be explained by the reaction of financial market participants to this specific event.
Uncertainty and political instability
Changes in risk can also affect expected returns and influence investors’ decisions about which assets (including currencies) to hold. Increased uncertainty around factors like future company performance, the economic outlook, interest rates and political stability can all make holding assets in a specific currency more risky, reducing or delaying investment flows (Pindyck, 1991).
The strong likelihood of greater trading frictions between the UK and the EU after Brexit amplified these risks for assets denominated in pounds. Research prior to the referendum predicted substantial falls in foreign investment in the UK as a result of Brexit-related trade costs (Dhingra et al, 2016).
These risks were compounded by substantial and persistent political instability in the UK, which prolonged and deepened uncertainty surrounding post-Brexit trading relationships and the likely economic outcome. The most substantial and persistent falls in the pound since 2016 were closely related to increased uncertainty and associated political turmoil.
One of the largest falls in sterling’s value relative to the euro occurred in 2017. This followed an early general election, which resulted in a hung parliament. In 2019, the pound fell to a new multi-year low against the dollar and the euro within days of Boris Johnson becoming prime minister and his refusal to rule out the possibility of a ‘no-deal’ Brexit – widely believed to be the worst possible economic outcome for the UK.
There is evidence that the negative consequences of this uncertainty for employment, productivity and investment in UK businesses were increasingly evident in the years immediately after the referendum (Bloom et al, 2019).
Expectations
The fall in the value of sterling occurred before Brexit had taken place. In contrast, exchange rate movements were relatively minor when the UK actually left the EU and the transition period ended at the end of 2020. This is because investors’ expectations are an important trigger that helps explain the timing of currency movements (Dornbusch, 1976; Engle and West, 2005).
Changing investor expectations are incorporated quickly into currency markets due to the sheer volume and speed of trade. Any new information that affects expectations about a currency will quickly be reflected in exchange rates. If market participants anticipate a negative future effect on investments in a currency, they will sell that currency, causing it to fall.
The record fall in the pound after the referendum illustrates the rapid impact of changing market expectations on currencies, as the Leave vote caught many commentators by surprise. Last-minute polling suggested that Remain was likely to win, which initially caused sterling to appreciate in the days before the referendum. The collapse in the pound’s value immediately after the result highlights the negative expectations that financial market participants had for sterling investments once the result became clear.
The large falls in the pound in 2017 and 2019 occurred during periods of heightened political uncertainty. These falls also reflect increasingly negative expectations for sterling-denominated investments caused by the growing likelihood of a ‘hard’ Brexit. Conversely, improved hopes of an orderly Brexit and a trade deal preceded increases in the pound’s value.
Recent research has demonstrated specific links between economic policy uncertainty and exchange rate expectations (Beckmann and Czudaj, 2017). Findings suggest that market participants will consider the level of policy uncertainty when forming their expectations.
What are the consequences of the fall in sterling?
One immediate consequence of a fall in sterling is that foreign goods, services and assets become more expensive for UK residents. This results in higher levels of inflation and a higher cost of living.
But a weaker currency can be beneficial since it can make exports more competitive by reducing the cost of domestic goods and services to residents of other countries. This can potentially have positive consequences for the country’s trade deficit and aggregate economic growth.
Research on the balance of these effects following a currency depreciation is mixed at best. In addition, uncertainty around the scale and implications of post-Brexit trade frictions persist, making the likely outcome for the UK even more unclear. In order to understand the longer-term consequences of the Brexit-related fall in sterling, further research is required.
