Analysis - Euro strength here to stay, unless ECB steps in

By Anirban Nag and Eva Taylor

LONDON/FRANKFURT (Reuters) - Many of the factors driving the euro exchange rate to levels that have set off alarm bells at the European Central Bank are unlikely to go away on their own, part of the reason the bank has been threatening action.

The euro is still off the peaks of 2011, but because inflation is now heading close to zero, the ECB is sensitive to its current rate because anything that makes it stronger pushes deflation nearer.

Mario Draghi, the ECB president, said at the weekend a strengthening exchange rate would trigger more policy action.

That could be some form of quantitative easing, or asset buying, to get more money into the system and hence make the euro cheaper.

Indeed, one reason for the euro's relative strength is that central banks in the United States and Japan have been printing dollars and yen for such bond-buying programmes, while the ECB's euro balance sheet has been shrinking.

"If the ECB really wants to get the euro down, then it can take a lesson from the Bank of Japan," said Nick Kounis, head of economic research at ABN AMRO. "Large scale monetary easing or quantitative easing tends to be bad news for your currency and tends to pull it down significantly."

The euro has gained 2.3 percent against the dollar and nearly 6 percent against the yen in the past six months. On a trade-weighted basis - against a basket of currencies - it stands just below recent 2-1/2 year highs, having risen 5 percent in 2013.

It is trading at around $1.38, slightly above the $1.36 rate on which ECB staff based their inflation forecasts through to 2016. The next staff forecasts are on June 5 and a downward adjustment could add ammunition for policy action.

MAGNET FOR INVESTORS

There are a number of reasons for the euro's strength.

For one, international, non-euro investors are returning to the currency bloc's stock and bond markets as the crisis-stricken region's painful budget adjustment programmes are beginning to bear fruit.

Greece, which had been locked out of capital markets for four years and was bailed out to the tune of 240 billion euros as its economy faltered, received bids seven times the amount in its first sale of a new bond since before its bailout in 2010.

Bank of New York Mellon also has seen robust inflows into bond markets of Portugal, Spain and Italy. Euro zone stock markets saw inflows worth more than $1.5 billion (893.1 million pounds) last week alone, according to UBS.

In Spain, which came close to requesting an international rescue in 2012, several real estate investment funds have raised money in stock market flotations, attracting prominent non-euro zone investors such as U.S. billionaire George Soros and bond fund Pimco.

Similarly, Blackrock, the U.S. fund house, is now Monte dei Paschi's biggest shareholder with 5.8 percent, and already holds

stakes in other Italian banks such as UniCredit and Intesa Sanpaolo.

All this will have required some shifts into euros.

"Structural changes (in euro zone crisis countries) are the magnet that attracts international capital and that has of course a positive impact on the valuation of the euro," said Folker Hellmeyer, chief economist at Bremer Landesbank.

FX flow data from UBS showed that net purchases of the euro/dollar last week was the highest since end-February, with strong demand from asset managers and hedge funds.

GLOBAL PRESSURE

Meanwhile, euro zone banks are repaying the cheap crisis loans they took from the ECB in late 2011 and early 2012 to ride out a period of tight funding.

This drains extra cash from the system and supports short-term money market rates and increases the euro's allure for investors seeking higher yields, especially money market mutual funds from the United States.

Traders also say some large Asian central banks, such as the People's Bank of China or the South Korean central bank, have been diversifying into euros in exchange of dollars they bought while intervening against their own currencies this year.

This diversification may well continue with Chinese forex reserves, the world's largest, rising to $3.95 trillion at the end of March from $3.82 trillion at the end of 2013.

Add to this capital inflows into the euro zone from euro zone banks repatriating money to meet regulatory and stress test requirements as the sector undergoes a thorough review by the ECB before it takes over as their new supervisor in November.

European banks have over $3 trillion exposure to emerging markets and as they have shrunk their size to meet regulatory requirements, they have repatriated capital back into the euro zone in the last quarter of December 2013, the Banks for International Settlements said.

This is reflected in the euro zone current account balance. The block's current account surplus hit a record high in January, soaring to 25.3 billion euros, and eased in February.

Analysts expect ECB rhetoric about the currency's strength to increase as the euro approaches $1.40, but unless it takes action, the euro is unlikely to fall much.

(Editing by Jeremy Gaunt)