The euro jumped on Friday on speculation that a new Chinese investment vehicle could provide much-needed funding to heavily indebted euro zone countries, helping tackle the region's debt crisis.
The single currency hit a session high of $1.3434, up 0.6 percent on the day, after Reuters on Friday reported that China's central bank plans to create a $300 billion vehicle to manage investment funds in the United States and Europe.
"The move higher is due to real money buying (in the euro) on the back of the China report," said Sebastien Galy, currency strategist at Societe Generale.
"It suggests it will make funding conditions easier for struggling euro zone countries."
In earlier trade, the euro had shown little reaction to an agreement by European leaders for tougher enforcement of euro zone budget rules, which did little to change investors' view that there would be no quick-fire solution to the euro zone debt crisis.
While some progress has been made to tackle the euro zone debt crisis, analysts argued it remained unclear whether European leaders have done enough to convince the European Central Bank to significantly raise the amount of bonds it buys from heavily indebted countries to stabilise their bond markets.
ECB President Mario Draghi welcomed the fiscal pact on Friday, but market participants noted that he offered few hints to the market that he would step up central bank bond buying after the ECB policy meeting on Thursday.
"The outcome of the summit is fairly positive, but while the summit can be seen as a pillar of support under the euro zone, the market is concerned that the ECB is taking away its pillar of support," said Michael Sneyd, FX strategist at BNP Paribas.
He added that the euro faced selling in the near term if the ECB fails to ramp up its bond buying next week. BNP Paribas targets the euro at $1.30 by year-end, and expects it fall to around $1.27-1.28 early in the new year.
The ECB has capped the maximum purchase of euro zone sovereign bonds at 20 billion euros a week for now and is not considering bigger action in response to the EU summit, ECB sources said on Friday.
The euro traded 0.6 percent higher at 104.27 yen, recovering from an earlier fall to 103.15 yen.
Gains in the single currency weighed on the dollar, pushing it nearly half a percent lower against a currency basket to 78.488.
Stocks rallied on the Beijing news, while currencies perceived to be higher risk trimmed earlier losses, suggesting an improvement in risk demand. The Australian dollar traded at US$1.0150, recovering from the day's low of $1.0048.
DOWNWARD RISKS
While EU leaders agreed stricter budget rules for the euro zone early on Friday, they failed to secure changes to the union's treaty covering all 27 member states, meaning a deal will only include the euro zone's 17 members, along with any others who wish to join.
Investors were also pessimistic about plans to lend an additional 200 billion euros to the IMF to help bail out weak countries, on the view that it would not be enough funding power to shield larger countries in trouble.
"The summit is still ongoing, but at the moment it's slightly negative for the euro," said Marcus Hettinger, global head of currency research at Credit Suisse in Zurich.
"The market is looking for a quick solution which is impossible ... Countries are reducing their deficits, which is negative for growth in the midterm, and this process will take time," he said, adding this would be negative for the euro down the line.
But he said the euro's sluggish performance also reflected the loss of its interest rate advantage against other currencies, after the ECB cut rates by 25 basis points to 1 percent on Thursday.
The euro has been pulled in both directions, and losses in the past few weeks have been limited despite the prospect of fundamental shifts in the structure of the European Union as policymakers scramble to solve the debt crisis.
But analysts said the euro has found some support as the year winds down with many investors, including hedge funds, unwilling to take on big positions in general having closed their trading books for 2011.
Fund repatriation by euro zone investors who need to reduce their foreign assets to bolster their balance sheets has also provided support to the single currency, they added.
read more: Olympus Wealth Management
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