* Nikkei up 0.8 pct, holds near 7-month highs
* Volume sinks to lowest since early August
* Shanghai drops almost 2 pct, but outlook for Nikkei bullish
By Antoni Slodkowski and Chikafumi Hodo
TOKYO, Dec 27 (Reuters) - Japan's Nikkei average rose 0.8 percent on Monday in thin trade as increased appetite for lagging Tokyo stocks in recent weeks helped to offset concerns over China's weekend interest rate hike.
Global stocks and commodities are hovering near multiyear highs on renewed confidence in global growth and investors have been particularly keen on Japanese stocks, which still down 2 percent in the year to date, are seen as relatively cheap.
Investors are raising equity holdings to a 10-month high, increasing exposure to high-yield credit and cutting back on government debt, Reuters polls showed last week. Several analysts expect the Nikkei to gain about 20 percent in 2011.
This underlying robust sentiment helped keep the Nikkei on a firm footing despite a volatile day for the Shanghai Composite Index which ended down 1.9 percent after rising more than 1 percent at one point in the morning session.
Other riskier assets like the Australian dollar dipped on the rate hike.
"Sentiment for the Nikkei is strong. In the next few days the market may try to test 10,500-10,600 and see if it can finish the year higher from the previous year's close," said Yutaka Miura, senior technical analyst at Mizuho Securities.
The benchmark Nikkei finished 0.8 percent or 76.80 points higher at 10,355.99, some 40 points shy of a seven-month high reached last Wednesday. It closed at 10,546.44 in 2009.
The broader Topix index gained 0.3 percent to 904.68.
The People's Bank of China increased its benchmark lending rate by 25 basis points to 5.81 percent and the benchmark deposit rate by 25 basis points to 2.75 percent.
"Market players knew that the rate hike was coming and the overall consensus is that China will continue with money tightening into the next year, so the negative reaction is limited," said Mitsushige Akino, general manager at Ichiyoshi Investment Management.
Other investors said, however, that with major Asian markets such as Hong Kong and Australia closed on Monday for the holidays, more time was needed to see the full market reaction to the rate increase.
"We want see how the U.S. market behaves in the wake of the credit tightening in China. But so far S&P 500 futures are calm," said Hideyuki Ishiguro, supervisor of investment strategy section at Okasan Securities.
March S&P 500 futures traded on Globex were down 0.3 percent in late Asian trade on Monday.
"Investors could be favouring stocks from developed countries which are maintaining easier monetary stances, while emerging markets are in a phase of tightening, so we may see more funds flowing into Japanese shares," he said.
Technical support could strengthen further if the Nikkei breaks through resistance at 10,420.74, where December futures and options contracts settled earlier this month, analysts said.
Shares of PC memory maker Elpida Memory rose 1.6 percent after a newspaper report that it will start talks on equity tie-ups with two Taiwanese chipmakers.
Volume dropped to 1.25 billion shares on the Tokyo Stock Exchange's first section. It was the lowest level since Aug. 9 and well below last week's daily average of around 1.6 billion shares. (Reporting by Chikafumi Hodo; Editing by Edwina Gibbs)