(c) 2013, Bloomberg News.

(c) 2013, Bloomberg News.

SYDNEY The euro, which reached a two-year high vs. the dollar this month, is poised to extend its gains as the European Central Bank's audit of the region's financial system encourages lenders to repatriate overseas assets.

Morgan Stanley says banks will "markedly" reduce net offshore assets that ECB data show rose to a record 613.5 billion euros ($841 billion) on Sept. 30. Royal Bank of Scotland Group Plc sees euro strength as lenders hasten the repayment of central-bank loans to clean up their balance sheets.

ECB President Mario Draghi said Oct. 23 the Frankfurt-based central bank won't hesitate to fail lenders as it trawls through the accounts of about 124 euro-area institutions to ensure they're solvent. The euro is the best-performer among developed- nation currencies this year, rising 6.7 percent versus a basket of nine peers, Bloomberg Correlation-Weighted Indexes show.

"Banks with huge positions in foreign currency-denominated assets will raise eyebrows during the asset-quality review," Hans Redeker, the head of global currency strategy at Morgan Stanley in London, said in an Oct. 29 phone interview. "These banks will continue to sell offshore assets and buy back the currency, pushing it to very high levels relative to fundamentals."

The 17-nation shared currency climbed to $1.3832 on Oct. 25, the strongest level since November 2011, according to data compiled by Bloomberg. It's up 3.9 percent since Dec. 31, headed for its best year since 2007, and has strengthened 1.3 percent in October.

Morgan Stanley recommends setting up trades that would profit from an advance to $1.42 by mid-December, when banks will probably have completed their foreign-asset sales, according to Redeker. It may then fall toward $1.25 in about a year, he said.

Examiners for the ECB's Comprehensive Assessment will first identify potentially problem loans, then review banks' balance sheets in early 2014, before conducting stress tests, which subject lenders to a series of crisis scenarios. It will then officially take over as the regulator for banks. The ECB has set an 8 percent capital-to-assets threshold for lenders.

Banco Bilbao Vizcaya Argentaria SA, Spain's second-biggest bank, said this month it sold a stake in China Citic Bank Corp. for 944 million euros to meet capital requirements. France's BNP Paribas SA cut its stake in Seoul-based Shinhan Financial Group Co. this month, saying it was part of "active balance-sheet management." Societe Generale SA is considering five suitors for its Asia private banking unit, a person with knowledge of the matter said this month.

Euro-area financial institutions had 3.9 trillion euros of offshore assets as of Sept. 30, compared with 3.3 trillion euros of overseas liabilities. The gap is the biggest in central-bank data compiled by Bloomberg going back to 1997.

The emergency loans taken out by euro-area banks under the Longer-Term Refinancing Operations program are also being repaid, helping shrink the ECB's balance sheet to 2.3 trillion euros as of Oct. 25, data compiled by Bloomberg show. The Federal Reserve's has increased to $3.8 trillion as of Oct. 23.

"European banks are probably looking to consolidate their balance sheets more rapidly now ahead of those stress tests, and that's probably contributing to the pace at which they're paying back LTRO funds," Greg Gibbs, a Singapore-based senior currency strategist at RBS, said in an Oct. 29 phone interview.

Gibbs said he sees the euro rising toward $1.45 in three months. RBS forecasts a decline to $1.20 in a year.

European lenders have undergone two rounds of stress tests in recent years, with the European Banking Authority carrying out the last formal reviews in 2011.

Only eight banks failed the exams, showing a combined capital shortfall of 2.5 billion euros. French-Belgian lender Dexia SA received a clean bill of health and then failed after a bank run three months later.

The new review, which starts in November and is due to end next October, is "our third and last chance to restore confidence," ECB Executive Board member Joerg Asmussen said this month.

Currency hedges by European banks on their foreign assets would limit the impact from repatriating euros, said Jens Nordvig, the New York-based managing director of currency research at Nomura Holdings Inc., Japan's biggest brokerage.

The stress tests would probably damp lending in Europe next year, which is "negative for growth and it should be negative for the euro," Nordvig said in an Oct. 29 phone interview.

That bodes ill for the currency bloc's recovery after the economy emerged from a record-long recession in the second quarter, growing 0.3 percent from the previous three months to end six-straight contractions. Gross domestic product will probably shrink 0.3 percent this year, according to the median estimate of 56 economists surveyed by Bloomberg.

With inflation falling short of the central bank's target, the ECB has scope to ease monetary policy further, Ian Pizer, the investment director of multi-asset and macro investing at Standard Life Investments, said in Sydney on Oct. 29.

Consumer prices rose 1.1 percent in October from a year earlier, a ninth-straight month below the ECB's 2 percent ceiling, a preliminary report today will show, according to the median forecast in a Bloomberg economist survey.

"A strengthening euro, on a longer-term time frame, is almost a self-correcting mechanism," Pizer said. "A stronger euro will lead through to forecasts of even weaker inflation and weaker growth from the central bank."

Futures traders have increased bullish bets on the euro this month to the most in more than two years, according to figures from the Washington-based Commodity Futures Trading Commission.

The difference in the number of bets by hedge funds and other large speculators on an increase in the euro against the dollar compared with those on a drop totaled 68,683 contracts in the week through Oct. 8, the highest since May 2011. Traders were betting on declines as recently as July 30.

Goldman Sachs Group Inc. predicts the euro will rise to $1.38 by Dec. 31 and strengthen to $1.40 in June next year.

"The biggest euro positive is that the asset-quality review is part of a key reform project in the euro zone and hence good for long-term investment," Thomas Stolper, the London-based chief currency strategist Goldman Sachs, said in an e-mailed response to questions on Oct. 30. "People who are underweight euro-zone assets have to think whether this is still justifiable given the steady reform progress."

_ With assistance from Michael Sin in Sydney.