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By Samuel Shen and Pete Sweeney
April 9 (Reuters) - Hong Kong stocks advanced to seven-year highs on Thursday in record turnover, but at the cost of Chinese markets, as mainland investors sought out the relatively cheap shares traded in the former British colony.
Betting that the huge valuation gap between the two markets would narrow, or even disappear, Chinese investors snapped up the entire 10.5 billion yuan ($1.7 billion) daily investment quota for buying Hong Kong stocks under the Shanghai-Hong Kong Stock Connect scheme.
It was the second day in a row that the quota was used up.
The sharp increase in buying was triggered by Beijing's move last week to encourage institutions, including mutual funds and insurers, to purchase Hong Kong shares.
"Currently, mainland money in Hong Kong's stock market is tiny, but in the future, it will play a big role," said Qiu Zhi, a strategist at Huatai Securities Co.
The Hang Seng index ended Thursday 2.7 percent higher at 26,944.39, the highest closing level since January 2008. The China Enterprises Index gained 2.6 percent to 13,748.37, having also touched seven-year highs.
But mainland stocks lost ground. The CSI300 index of the largest listed companies in Shanghai and Shenzhen lost 0.8 percent, while the Shanghai Composite Index fell 0.9 percent.
Even after the recent surge in Hong Kong stocks, Chinese companies still hold a 24 percent premium, according to an index
measuring price differences between shares of dual-listed companies..
The valuation gap is even bigger for small caps. China's Nasdaq-style ChiNext board trades at 94 times companies' earnings, compared with a price/earnings ratio of about 12 for Hong Kong's Growth Enterprise Market.
"The rally in the Hong Kong market is sustainable, because many stocks there are indeed undervalued," said Qiu of Huatai Securities.
Thursday's trading was volatile in China, especially for ChiNext, which slumped as much as 5.7 percent at one stage but ended the session flat.
The only bright spot in the Chinese market was real estate stocks. The real estate sub-index surged nearly 6 percent after news that Shanghai had relaxed lending rules to aid the struggling sector.
Reporting by Samuel Shen and Pete Sweeney in Shanghai; Editing by Alan Raybould