Brexit and Exchange Rates: Causes and Consequences

University of Birmingham

Since the Brexit referendum on the 23rd June 2016, the pound has lost about 11% of its value against the euro and about 6% against the US dollar. The Brexit vote was undoubtedly responsible for much of the decline; if the vote had been to remain the pound would almost certainly have appreciated, so the difference the referendum result made was greater than these figures suggest.

Why did the Brexit vote cause the decline? One plausible explanation is that it happened because of the anticipation of the UK facing inferior trading relationships after its withdrawal. Membership of the EU has considerable benefits as far as the UK’s trading relationships are concerned: these benefits include: (i) tariff-free access to EU markets with no customs checks; (ii) influence over the rules and regulations of the single market and (iii) participation in the free trade agreements the EU has negotiated (and is continuing to negotiate) with other countries. The UK will certainly lose the first two advantages of being in the EU. As far as (iii) is concerned, it may over time, negotiate preferential trade agreements of its own with other countries which may substitute for its participation in the EU’s agreements, but the extent to which this will happen of course remains to be seen.

Even if there is a free trade agreement with the EU, if the UK wishes the freedom to agree free trade agreements with other countries, trade between the UK and the EU will need to involve the preparation of certificates of origin by firms and customs checks. This is to prevent firms in countries with which the UK has a preferential trade agreement (but with which the EU does not) from being able to export goods to the EU tariff free by sending them first of all into the UK and thence into the EU. There seems to be no way round this; possibly with ingenuity and technology the process can be made as smooth as possible, but there will need to be customs checks of some sort. These additional complications involved in trading with the EU will undoubtedly tend to reduce UK trade with the EU and the complex international supply chains underlying the production of many goods will be disrupted. So leaving the EU means an inferior trading relationship with the rest of the world, so to compensate, (trade must balance, at least approximately, over the longer run) the exchange rate has to depreciate.

The nature of the final trade trade deal the UK negotiates is by no means clear. It is difficult to be optimistic. The UK is not in a strong bargaining position - if the UK were to exit with no deal, its trade relations with the 27 EU countries and all the countries with which the EU has preferential trading relations will immediately deteriorate. However, for each of these countries the UK’s exit would mean that their trading relationship with just one country (the UK) deteriorate. So the UK has much more to lose from a ‘no deal’ outcome than any of the EU countries (with the possible exception of Ireland). Divisions in the government as to what it wants do not help, and the UK is not particularly experienced at negotiating such deals. As expectations change as to the outcome of the negotiations, we would expect to see further changes in the exchange rate.

Exports should rise as a consequence of the exchange rate depreciation,. However, this effect is mitigated in several ways. Given the uncertainty about future trading arrangements, exporters are unlikely to put much effort into developing new export markets. Also, many exporters buy imports as inputs into their productive processes. As the prices of these imports may well have risen because of the depreciation and might be expected to rise still further, this will have an offsetting effect.

It must be remembered that only a fraction of firms export. But a firm that produces just for the domestic market may still buy imported inputs, so is likely to suffer unless it faces significant competition from imported substitutes for its final product.

The depreciation of the pound has undoubtedly contributed to the rise in inflation since the referendum result. But other factors such as the increase in the world price of oil, have also contributed. After a period of falling real wages (prices have risen faster than wages) real wages have now at last started rising mildly. The most likely scenario is that inflation will gradually converge to the government’s target of 2%, but that disposable income will increase (if at all) at a fairly modest rate. With continuing slow growth of productivity (partly because of Brexit), the longer run growth in disposable income is likely to be modest as well.  

John Fender
University of Birmingham

The University of Birmingham is a member of the GBCC Brexit Advisory Group which is working hard to support businesses through Brexit. If you are looking for support and advice on Brexit, make sure you check out the GBCC Brexit Toolkit which sets out suggestions for how businesses can get “Brexit ready”, facts and stats on Brexit and the region’s relationship with the EU. The Toolkit also contains our Brexit manifesto which includes what businesses need to see from stakeholders on Brexit negotiations and beyond.