* Euro hits 11-month peak vs dollar, 21-month high vs yen * Banks to pay back more ECB loans than expected * German Ifo data fuels demand for euro By Nia Williams LONDON, Jan 25 (Reuters) - The euro hit an 11-month high versus the dollar on Friday after the European Central Bank said banks will repay 137 billion euros in cheap loans, reassuring investors that the banking system is on the mend. The single currency also hit a 21-month high against the yen, helped by evidence of an economic upturn in Germany. The ECB said 278 banks had decided to repay the three-year crisis funds at the earliest opportunity next week, and the total amount was more than the 100 billion euros forecast by traders. Strategists said banks' willingness to hand back the loans would bolster confidence in the currency bloc and could help the euro break through $1.35 in coming days. The single currency rose 0.6 percent on the day to $1.3465, its highest level since late February 2012. The next near-term target for the euro is the 2012 high of $1.3486. "Banks are in better shape than we thought before and the higher (repayment) number is better for euro/dollar. Plus the ECB is the only central bank amongst the majors that is contracting its balance sheet," said Peter Kinsella, currency strategist at Commerzbank in London. "The euro could push through $1.35 but I'm not sure it's got legs past $1.37," he added. 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. Balance sheet expansion by a central bank usually hurts a currency as it increases its supply. Data showing German business morale improved for the third month in a row in January, adding to signs growth in Europe's largest economy is picking up, also fanned demand for the euro. The single currency rose more than 1 percent against the yen to 122.50, its highest level since mid-April 2011. "The Ifo number has been supportive of the euro and investors want to go long," said Geoffrey Yu, currency strategist at UBS. "It's all about momentum now, and data like this only helps." The euro has gained nearly 1 percent against the dollar and 1.8 percent against the yen this week as investors bet on more gains, encouraged by falling euro zone peripheral bond yields. In the options market, traders reported demand for euro calls - or bets on more gains. One-month risk reversals traded at 0.05 vols in favour of euro calls, having flipped from euro puts. BMO Capital Markets said it was the first time the one-month had traded in this direction since October 2009. YEN WEAKENS The yen came under renewed pressure after reports on Thursday quoted Japan's deputy economy minister as saying the yen's decline was not over, and that a dollar/yen level of 100 would not be a concern. The dollar rose to a 2-1/2 year high of 91.04 yen, rising past reported options barrier at 90.75 and 91 yen. The U.S. currency has gained more than 14 percent since mid-November. The yen's steep drop since late last year and government efforts to ease fiscal and monetary policy have raised eyebrows abroad, with German Chancellor Angela Merkel singling out Japan on Thursday as a source of worry. Japanese Finance Minister Taro Aso, shrugging off the concerns, said on Friday the monetary easing was aimed at pulling the country out of deflation, not manipulating currencies. The dollar index inched lower to 79.83 as dollar strength against the yen was outweighed by weakness against the euro.