LONDON, Dec 2 (Reuters) - The euro is poised to become the best performing major currency of 2013, defying expectations of weakness for another year but complicating the European Central Bank's fight to avert deflation.
With European banks repatriating money to comply with regulatory requirements before year-end, and the euro zone running a hefty current account surplus, the euro is likely to remain in demand in coming months.
But a strong euro is not universally welcomed. By cutting the price of imports, it contributes to the slowing of euro zone inflation that prompted the ECB to cut interest rates to a record low at last month's meeting, although ECB chief Mario Draghi said the exchange rate was not discussed.
Even after the cut, ECB rates remain higher than those of the U.S. Federal Reserve and the Bank of Japan, making the euro a more attractive investment.
And the possibility of further rate cuts is not seen undermining the euro much. Analysts contrast the monthly contraction in the ECB's balance sheet as banks repay cheap loans taken during the euro zone debt crisis, with the Bank of Japan and the Federal Reserve pumping trillions of dollars into the economy every month.
"The euro will continue to look like a short-term winner, but a loser in the global central bank race to the bottom (the race to have the most competitive currency), and a long-term loser in the global fight against deflation," said Lena Komileva, managing director at G+ Economics.
The euro's resilience, despite a patchy economic recovery, has confounded expectations. In December 2012, analysts in a Reuters poll forecast it would drop to $1.25 in 12 months. But on Monday it stood at $1.35. It was a similar story in 2012, when the euro ended the year higher despite the threat of Greece leaving the currency bloc.
The ECB's efforts to ensure the stability of euro zone banks, some of which will have little choice but to sell overseas assets and bring funds home, are likely to support the euro into 2014.
"The euro is higher because banks repatriating funds do not look at economic fundamentals and yield differentials," said Hans Redeker, head of global currency strategy at Morgan Stanley, who estimates fair value for the euro at around $1.29.
The ECB's asset quality review (AQR) will assess the quality of banks' assets, based on balance sheets at the end of 2013. Stress tests will be conducted later, with the process due to finish by October 2014.
"As we approach October (2014) there are likely to be more flows. If anything, this is a trend which will continue," said Nick Bullman, chairman of risk management consultants CheckRisk.
ECB'S LIMITED ARMOURY
The euro fell sharply immediately after the ECB cut rates but soon reversed its losses. It has since hit a one-month high against the dollar, a five-year peak against the yen and is near its strongest in two years against a trade-weighted basket of currencies.
The ECB has mooted further rate cuts, even if it means forcing banks to pay to park money with the central bank. They may also opt for more cheap loans to banks.
These would weigh on the euro but may not significantly reduce its allure, at least until a scaling back of the U.S. Federal Reserve's asset purchase programme looks imminent.
"Until the ECB considers going beyond rate action, towards more substantial quantitative stimulus, the euro will remain supported due to uncertainty over the timing of Fed tapering," said G+ Economics' Komileva.
Earlier this month, ECB Executive Board member Peter Praet raised the prospect of the central bank implementing some form of quantitative easing by starting to buy assets. But most analysts view QE from the ECB as unlikely.
"The euro is strong because the ECB has less room in its toolbox ... People realise that the ECB is hampered, while other central banks can undermine their currencies," CheckRisk's Bullman said.
(Editing by Nigel Stephenson and Catherine Evans)