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.
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