* Stock connect is major step in opening China's market
* Northbound quota fully used, only 17 pct used for southbound
* Shares fall on profit-taking, long-term impact seen positive (Updates with market close)
By Kazunori Takada and Saikat Chatterjee
SHANGHAI/HONG KONG, Nov 17 (Reuters) - International buyers snapped up Chinese stocks on Monday at the debut of an exchange link that allows Hong Kong and Shanghai investors to trade shares on each other's bourses, a major step towards opening China's tightly controlled capital markets.
The so-called Stock Connect scheme gives foreign and Chinese retail investors unprecedented access to the two exchanges, which some analysts said could eventually lead to the creation of the world's third largest stock exchange.
Northbound trade - investors with Hong Kong accounts buying mainland shares - far outstripped trade from mainland investors in the opposite direction, with the daily limit for buying Shanghai stocks under the scheme exhausted by mid-afternoon.
But there was no sustained first-day bounce in prices - benchmark mainland and Hong Kong indexes opened more than 1 percent higher but soon sagged to close lower on the day.
The run-up to the launch saw a strong market rally, partly on expectations of an increase in fund flows from the scheme, leaving investors cautious of chasing stocks any higher, said Zheng Weigang, senior trader at Shanghai Securities.
"In the longer run, however, the connect will surely benefit both markets as China increasingly opens up to the outside world," Zheng added. "Particularly, the connect will help push the mainland's rampant speculative stock culture towards a more investment-oriented market."
The CSI300 index of top Chinese shares closed down 0.5 percent while the Shanghai Composite Index fell 0.2 percent. The Hang Seng Index in Hong Kong ended down 1.2 percent.
Analysts had expected much of the initial cash flow to be northbound, with foreign investors on the Hong Kong Exchange able to collectively buy up to a daily quota of 13 billion yuan ($2.12 billion) of mainland stocks.
The expected fund inflow had helped push the SSE180 Index and the SSE380 Index - the two main Chinese destinations for foreign investment through the scheme - up more than 10 percent and 6.5 percent since late last month.
Southbound investment, capped by a daily quota of 10.5 billion yuan, is likely to be less active.
All the daily northbound quota was used by mid-afternoon, but just 17 percent of the southbound quota had been taken by the market close.
The launch of the stock link scheme, also dubbed the "Through Train", comes as Beijing steps up its financial market liberalisation efforts this year.
It has established offshore yuan centres from Sydney to London, signed swap lines with countries in the Middle East and has allowed foreign companies in China to move renminbi across borders with greater freedom than ever before.
But it also comes as a time when concerns over the world's second biggest economy are mounting. Underscoring such worries, Chinese banks' bad loan ratio rose to 1.16 percent at the end of September, up 0.09 percent points from June, the banking regulator said on Saturday.
"It took a longer-than-expected period of time for such a small daily quota to be used, indicating overall sentiment in Shanghai remains cautious," said Zhang Gang, senior analyst at Central Securities in Shanghai.
Turnover in both markets were roughly in line with daily numbers. Over the longer term, however, the stock connect could boost the average daily value of stock trading in Hong Kong by about 38 percent by 2015, French bank BNP Paribas estimates.
"Chinese investors will take Hong Kong as a place to put their long-term bets. So that's why I think in the long-run Hong Kong will benefit from this," said Alex Wong, asset management director at Ample Finance Group in Hong Kong.
For Shanghai, it is significant because it will allow foreign investors to get more actively involved in China's capital market, he added.
China already operates several cross-border investment schemes, but these are restricted to specific firms that must apply for a licence to participate.
The Stock Connect programme was originally expected to launch on Oct. 27, but that unofficial deadline passed, leading to speculation that the programme might be held up by technical or political hurdles.
The differing tax rules applying in Hong Kong and the mainland were also a major stumbling block, but China's Finance Ministry said on Friday that it would temporarily exempt taxes on profits made from the Connect scheme.
Hong Kong's leader CY Leung has hinted that the ongoing pro-democracy protests in the city had also played a role in the delay. (1 US dollar = 6.1267 Chinese yuan) (Additional reporting by Lu Jianxin in SHANGHAI, Yimou Lee in HONG KONG and Shanghai newsroom; Editing by Will Waterman and Alex Richardson)