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NEW YORK, Nov 25 (Reuters) - Europe is no longer the forbidden zone for U.S. money market funds, which have been adding to their holdings of securities from the region's banks after slashing their exposure during the height of the euro zone debt crisis two years ago.
Fund managers and analysts said the revived demand for bank paper in particular from German and French banks is underpinned by tentative signs the region is climbing out of a recession.
"Europe continues to have the highest shock risk from a banking perspective than any other region, but clearly those concerns about Europe's financial shocks have been radically reduced in the past 12 to 18 months," said Tom Nelson, chief investment officer at Reich & Tang, a New York-based money market management firm.
The debt costs of Greece and other cash-strapped euro zone member nations have fallen sharply this year, partly due to support from the European Central Bank. This has thawed some of the reluctance among U.S. money fund managers to hold euro zone bank debt.
U.S. prime money market funds, which can invest outside of U.S. government securities, raised their euro zone holdings in October to the highest level since August 2011, according to a report by JPMorgan Securities released earlier this month.
Prime money funds' exposure to the euro zone grew by $22 billion to $251 billion last month. Since the end of 2012, the funds have raised their holdings of that region's bank paper by $49 billion, JPMorgan said in a Nov. 13 report.
The money funds JPMorgan tracks held nearly $1.1 trillion in assets at the end of October, equivalent to 42 percent of the $2.6 trillion U.S. money fund industry. They are major investors in short-term bank debt worldwide.
However, it is unlikely the 17-nation block will return to its glory days when money funds held roughly a fifth of their cash in euro zone bank debt, prior to the onset of the region's sovereign debt crisis.
France, Italy and Spain, which are the euro zone's second, third and fourth biggest economies, continue to struggle with record unemployment and heavy debt loads.
"I say less jitters, I wouldn't say more confidence yet," said Deborah Cunningham, chief investment officer of money markets at Federated Investors Inc in Pittsburgh.
Fund managers also attributed the rebound to the euro zone banking system showing resilience in the wake of Cyprus's fiscal woes this past spring, which some traders had feared would destabilize the bank system.
"People had thought Cyprus was going to be a big problem and when it wasn't, it just made people more comfortable with the entire euro zone area which has a lot more depth and strength to it than was initially thought," Cunningham said.
The bulk of this year's increase in euro zone exposure has been in French and German bank debt. It grew by $10 billion to $151 billion and by $9 billion to $43 billion respectively in October.
Revived demand for French bank debt ranks them fourth in terms of holdings by country, just behind Canada, JPMorgan analysts wrote in the report. But their French holdings were some $73 billion below the peak seen in May 2011.
"France was obviously the biggest concern at one point back in 2011. They seem to be back on everyone's radar," Federated's Cunningham said.
The data were collected prior to Standard & Poor's downgrade of France's debt rating on Nov. 8 to double-A from double-A-plus.
Large French and German banks can now sell overnight and short-term debt to money funds at the same or slightly higher interest rates as their U.S., Japanese and Canadian counterparts. A year ago, they had to offer interest rates anywhere from 0.05 to 0.20 percentage point higher.
Another factor behind money funds' partial return to euro zone bank debt has been because securities from countries including Australia and Canada are perceived as more expensive.
"Canadian and Australian paper have gotten extremely rich," Reich & Tang's Nelson said. "In the meantime, the risk and reward of European paper has become more attractive today than they did 12 months ago."