The frenzy that made Chinese stocks the world’s best performers is spilling over the border into Hong Kong.

After propelling the Shanghai Composite Index to a 90 percent rally in the past 12 months, mainland investors are buying as many Hong Kong equities through the exchange link as regulators will allow. Turnover in the former British colony jumped to a record on Wednesday, volatility surpassed that of Shanghai and the Hang Seng Index surged the most since 2011. The rally spilled over into New York, with a Bloomberg index of U.S.-traded Chinese companies surging to a record high.

Hong Kong’s $4.7 trillion stock market is catching up with its Chinese counterpart after valuation discounts in the city reached the most extreme levels since 2011 and mainland authorities made it easier for domestic funds to use the cross-border bourse link. Columbia Threadneedle Investments and ABN Amro Private Banking say price gaps will keep shrinking as investors look for cheaper ways of betting on a recovery in the world’s second-largest economy.

“We’ve got the domestic liquidity from China making a statement that the Chinese economy is doing fine and shares are undervalued in Hong Kong,” said Ng Soo Nam, the Singapore-based head of Asian equities at Columbia Threadneedle, which manages about $506 billion globally. “Liquidity can now move between the two markets as there are less restrictions.”

On the mainland, stocks are surging as investors open new trading accounts at an unprecedented pace and take out record loans to buy shares.

The rally pushed prices for yuan-denominated A shares to the most expensive level in three years last month versus their dual-listed Hong Kong counterparts, known as H shares, according to the Hang Seng China AH Premium Index. The premium has slipped to 28 percent from its March 26 high of 36 percent.

David Fuller's view

Mark Mobius, who has seen it all, says China stocks face 20% drop.

That is a real risk but I believe he is talking about the Shanghai A-Shares Index.

However, the article quoted immediately above points out that H-Shares – that is the HSCEI Index in Hong Kong – is trading at a 26% discount to the A-Shares Index.  Therefore, now that liquidity can move between the two markets with fewer restrictions, we are looking at a potential catch-up play.  However, the really important question is when will China crack down on this trade? 

I do not know because that is up to Xi Jinping and his closest allies, and they may not have decided when to blow the whistle on this trade.  Judging from the HSCEI chart pattern, it could have a way to run.

p>