Watch the Hong Kong and Chinese mainland stockmarkets. If you think there’s a bubble now, just wait. It seems securities regulators in China are toying with the idea of allowing arbitrage between stocks listed on mainland exchanges (Shanghai and Shenzhen) and Hong Kong.

It has got American investors, especially those trading giants, the big investment banks, hedge funds and other, salivating. So much so that Chinese stocks trading on US markets had their biggest rise in six years overnight.

Chinese shares are more expensive in Shanghai and Shenzhen than in Hong Kong and the US because of limits on inward and outward investment from the mainland. According to reports in Bloomberg and on the Financial Times website, China’s securities regulator says it will study a plan to end price discrepancies.

There are worries that a bubble is building because China’s CSI 300 Index has almost tripled this year. The USX China Index, which tracks US traded shares of 74 mainland companies, jumped 8.3% overnight, the biggest advance since April 2001.

Bloomberg said that Tu Guangshao, vice chairman of the China Securities Regulatory Commission, said in Beijing that the panel is studying a proposal to allow swaps in shares of companies traded on domestic and Hong Kong exchanges.

Companies on the CSI 300 index trade at an average 56 times reported earnings, compared with 34 times for the USX China Index. Stocks listed in Hong Kong, as measured by the Hang Seng China Enterprises Index, have an average P/E multiple of 31.

China’s regulators have been arguing over plans to give individuals more freedom to invest overseas. It was proposed mid-year, then reports say it is being held back for fear that allowing greater freedoms (always a worry in China) will see a huge outflow of money (after all China needs every one of its $US1.43 trillion in foreign reserves).

But to allow freer overseas investment would put pressure on China’s controlled currency, the Yuan, meaning there would then be pressure on the government to allow that to float more easily, or to be fully convertible into other currencies, such as the US dollar.

The Government (Communist Party) doesn’t want to do this because it knows the currency would appreciate very quickly, hurting industry and the country’s expansion program. So this arbitrage idea has been thought up it would seem as a sop to those who want greater freedom to investment, and those worried about the outflow and the perils of those freedoms.

What the Chinese seem to be ignoring is that the prices of Chinese shares listed in Hong Kong and the US (and on other markets) will rise rapidly towards the level of mainland prices, promoting price bubbles on Wall Street and in Hong Kong. That actually could hurt the Australian market by diverting money coming here for greater returns, into punting on the price differences between Chinese listed and overseas listed Chinese shares.

It seems to be what local investors haven’t appreciated this morning.

While allowing the Chinese to continue to control outward investment (and inward investment) it would produce a series of external bubbles, which would be just as threatening as the bubble on China’s domestic markets at the moment.