* Euro zone banks to repay more ECB loans than expected * German business confidence data fuels demand for euro * Yen weakness continues; Japan defends yen policy By Wanfeng Zhou NEW YORK, Jan 25 (Reuters) - The euro rallied to an 11-month high against the dollar on Friday on growing optimism the region's debt crisis has turned the corner, while the yen was headed for its 11th consecutive week of losses against the U.S. currency. The euro zone common currency also hit a 21-month peak versus the yen after the European Central Bank said banks would pay back a greater-than-expected 137 billion euros in loans next week, a sign that at least parts of the financial system are on the mend. "For now, the trade of 'buy euro, sell yen' seems to be in play," said Win Thin, senior currency strategist at Brown Brothers Harriman in New York. The euro climbed 0.7 percent to $1.3469, having risen to $1.3479, its highest since late last February. On the week, it gained about 1.2 percent. A survey showing improvement in business confidence in Germany also underpinned the euro strength, putting it on track for its best one-day gain in two weeks. The ECB is the first major central bank to start moving away from unconventional monetary policy measures, unlike the U.S. Federal Reserve and Bank of Japan, which are buying bonds to stimulate growth. When a central banks purchases assets, effectively expanding its balance sheet, the country's currency tends to be hurt because it increases the currency's supply. Reflecting a dramatic improvement in the euro zone's funding conditions, the cross currency basis swap, or the relative premium for swapping euro Libor for dollar Libor, on Friday traded at -17.5 basis points on three-month contracts , the lowest premium in 20 months. A lower swap premium suggests fewer demand for the greenback and diminished funding stress in the euro zone. Two-year German bond yields jumped to their highest since March 2012 and rose above their U.S. counterparts for the first time in two years, suggesting interest-rate differential is moving in favor of the euro, analysts said. In the options market, traders reported demand for euro calls, which are bets on more gains, although one-month risk reversals on Friday still showed a minor bias for puts or more euro weakness. However, this was the smallest euro put level since November 2009. The dollar rose as high as 91.19 yen, the strongest since June, 2010, rising past reported options barrier at 90.75 and 91 yen. It was last up 0.8 percent at 91.07 yen. On the week, the dollar rose about 1 percent versus the yen, and has gained every week versus the yen since the week ended Nov. 11. Expectations Japan's new prime minister, Shinzo Abe, will force the central bank to aggressive ease monetary policy has cause the yen to lose more than 10 percent of its value against the dollar since mid-November, and many expect more declines. The yen's steep drop has raised eyebrows abroad, with German Chancellor Angela Merkel singling out Japan on Thursday as a source of worry. But Japanese Finance Minister Taro Aso said Friday that monetary easing was aimed at pulling the country out of deflation, not manipulating currencies. BNP Paribas in a note said the yen's downside momentum remained strong, but the back-and-forth statements about the currency's weakness between foreign politicians and Japanese officials should exacerbate volatility. The euro rose 1.5 percent to 122.61 yen putting it on track for a weekly rise of 2.2 percent, the seventh straight week of gains. It had earlier touched 122.77, its highest level since mid-April 2011.