* Nikkei drops 0.7 pct as yen hits 3-week high vs dlr
* Exporters, precision machinery makers drop on strong yen
* Advantest up 4 pct on news on buyout offer for Verigy
* Shanghai stocks fall on report of China rate rise
By Chikafumi Hodo
TOKYO, Dec 7 (Reuters) - Japan's Nikkei average fell 0.7 percent on Tuesday after renewed strength in the yen encouraged profit-taking and after sentiment was hurt by a report that China's central bank may raise interest rates this weekend.
M&A news found chip equipment maker Advantest in favour, with the stock jumping 4 percent after it made a $729 million buyout offer for U.S. rival Verigy Ltd.
But shares in airconditioner maker Daikin dropped on a report it was in talks to buy U.S. heater and airconditioner manufacturer Goodman Global Group.
"The yen's firmness is putting pressure on the Nikkei. Shares of precision machinery shares are especially under pressure due to the yen's strength on the euro," said Hiroaki Kuramochi, chief equity marketing officer at Tokai Tokyo Securities.
"So far we are not overly worried about the yen's recent recovery, but we'll be more concerned should the yen approach 80 (against the dollar)."
Shares in Shanghai and Hong Kong fell after the official China Securities Journal reported in a frontpage story that China's central bank may tighten credit.
"We are watching how the market digests the latest report on the rate hike," said Mitsushige Akino, chief fund manager at Ichiyoshi Investment Management.
"A steep drop in Chinese shares could drag down Japanese shares sharply, but a modest drop could be positive for Japanese shares if this would trigger moves by overseas investors to allocate funds into Japan," Akino said.
The benchmark Nikkei closed the morning session down 65.60 points, at 10,101.63 while the broader Topix index fell 0.6 percent to 876.55.
But investors were unwilling to sell actively on the view that Japanese shares are still on an upward trend, analysts said. The Nikkei rose 8 percent in November.
Market participants were also hesitant about taking large positions in the Nikkei ahead of the closely watched settlement of futures and options prices on Friday.
The settlement, known in Japan as the special quotation or "SQ", is calculated from the opening prices of the 225 shares on the Nikkei average on the second Friday of the month.
Many participants appeared to have finished rolling over their positions to the March contract, a Tokyo-based options trader said, adding that he expects contracts expiring in December will settle around 10,050-10,300.
The euro was under pressure in Asia on views that the euro zone appeared split on how to resolve the region's debt crisis while the dollar slipped to a three-week low against the yen to under 82.52 yen.
Shares in Funai Electric rose 6.5 percent to 2,954 yen after Bank of America Merrill Lynch raised its rating to "buy" from "underperform" and hiked its target price to 3,800 yen from 2,100 yen, citing receding inventory problems for Philips-brand TVs. (Editing by Edwina Gibbs)