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Chinese Role Suspected In

Puzzling Euro Strength

   By Katie Martin    Of DOW JONES NEWSWIRES  

LONDON (Dow Jones)--Conspiracy theories are starting to swirl around the currencies markets as traders struggle to explain the euro's baffling strength against the dollar.

With the euro-zone debt markets under even more pressure every day, the single currency should be falling fast, judging from recent patterns. Instead, it has been holding firm, for no compelling fundamental reason.

Now, some market-watchers believe that China could be buying euros on a big scale to keep supported the currency, and keep the dollar relatively weak, in a move designed to limit its own currency's gains in the wake of its decision to depeg the yuan from the dollar.

"The stability of the euro in the face of building sovereign debt problems and fears that banks are relying more heavily on European Central Bank funding is puzzling," said the analysts at the Royal Bank of Scotland in a note to clients Friday.

"It has some wondering if the return of China to a more flexible basket currency policy has coincided with a decision to resume purchases of euros to diversify reserves," the bank said.

An urge to engineer a little dollar weakness against the yuan, without excessive yuan strength, ahead of this weekend's meeting between the Group of 20 most industrialized nations, could also be behind the move, RBS suggests.

China releases very few details of its dealings in foreign currencies, so such theories are difficult, if not impossible, to prove or disprove. Still, they offer a compelling explanation for a confusing period of strength in the euro. If true, the euro stands to fall heavily as investors judge its rally to be down to artificial factors rather than a genuine improvement in the euro-zone fiscal crisis.

The euro dipped to a four-year low against the dollar earlier this month at $1.1876, as the currency bloc's debt crisis appeared to spiral out of control and economists started to mull seriously whether the currency union was sustainable.

That debt problem has not improved markedly since. Indeed, the gap in yields between the safest government bonds in the region--Germany's--and those from more wobbly states such as Greece and Spain, have remained stubbornly wide, indicating concern among investors for holding bonds from the most indebted euro-zone states.

Friday, the cost of insuring Greek government debt against default rocketed to a fresh record high, with five-year credit default swaps quoted at over 1000 basis points, albeit in jerky, illiquid trading conditions.

That means it costs over $1 million a year to insure $10 million of Greek government debt against default, according to data provider CMA DataVision.

Despite this continuing stress, the euro rallied as high as $1.2490 on June 21, immediately after China dropped the yuan's peg to the dollar on June 19.In all, it made an unusually large 5% climb against the dollar in the past two weeks.

The rally was more pronounced and long-lived than that seen after euro-zone leaders and the International Monetary Fund unveiled a $1 trillion aid package for the euro's troubled states in May.

Most market-watchers have attributed this runup in the euro to so-called short covering, where investors who had placed negative bets on the euro took profit on their bets. A dwindling supply of euro sellers is also thought to be playing a role, and while the euro-zone debt crisis has not improved, it has not deteriorated markedly either.

At 0910 GMT, the euro was experiencing a fresh bout of selling pressure, dipping to $1.2269 against the dollar, from the day's high of $1.2352. The single currency also hit a fresh record low against the Swiss franc Friday, at CHF1.3505.

By Katie Martin, Dow Jones Newswires; 44 20 7842 9346; katie.martin@dowjones.com