SHANGHAI • China is dishing out a tough lesson to currency traders and strategists alike: Don't bet against the yuan.

Yesterday, the currency jumped to its highest level in seven months offshore, extending Wednesday's gain of 1.2 per cent, despite analyst forecasts for declines this quarter.

Surging interbank rates are squeezing currency bears by driving up the cost of short positions.

The rally, which broke months of calm against the greenback, comes as a rebuke to Moody's Investors Service, which downgraded China's sovereign debt rating on May 24.

The Chinese government has made its displeasure clear, calling the move "absolutely groundless".

The central bank had already been tackling pessimistic traders by repeatedly strengthening the yuan's daily fixing, while an opaque change to the setting, announced on May 26, added to the complexity of betting on future movements.

"The Moody's downgrade and a weaker spot rate compared with the fixing could have spurred the authorities to change the fixing mechanism and potentially intervene in the market," said Mr Jason Daw, the Singapore-based head of emerging-market currency strategy at Societe Generale.

The onshore yuan rose 0.4 per cent to 6.7935 per United States dollar in morning trade in Shanghai, after fluctuating in a narrow band at around 6.9 for most of the year.

The rate in Hong Kong rose 0.2 per cent, taking the gain to 2.2 per cent since the Moody's downgrade.

The city's overnight deposit rate touched 65 per cent on Wednesday, while the spread between offshore and onshore exchange rates was at its widest since March.

Propping up the yuan has been a policy priority this year as the Chinese authorities try to stem capital outflows and prevent financial shocks before an important leadership reshuffle in the ruling Communist Party late this year.

The stakes have increased in recent weeks following a regulatory clampdown on leverage-roiled domestic bond and equity markets.

The role of government intervention in the latest squeeze is unclear, but people familiar with the matter have said in recent days that Chinese banks were selling US dollars both offshore and onshore, while the central bank consistently set reference rates last month that were stronger than analysts predicted.

The surge in interbank rates echoed similar moves in January this year and last year that ended up burning bears.

On May 26, the government said policymakers might add a "counter-cyclical factor" to the yuan's daily fixing. Analysts said the change would give the authorities more control over the fixing, and could restrain the influence of "herd behaviour" in the market.

The People's Bank of China (PBOC) could also be seeking to shore up the yuan before a possible interest-rate hike in the US, according to senior currency analyst Fiona Lim at Malayan Banking.

"The PBOC is probably trying to introduce more guidance for the yuan now, in order to boost market confidence ahead of a prospective dollar rally," said Ms Lim.

"The fixing is now less transparent, and the influence of the market has been limited."

BLOOMBERG