Chinese shares slid and European stocks followed suit on Monday as the impact of China's Christmas Day interest rate rise sunk in to thin markets.

Chinese shares dropped 1.9 percent after the People's Bank of China raised interest rates on Saturday for the second time in just over two months.

European stocks were 0.7 percent lower by 1025 GMT (5:25 a.m. ET) in trading pared to the bone by a market holiday in Britain.

The PBOC said it would raise the benchmark lending rate by 25 basis points to 5.81 percent and lift the benchmark deposit rate by 25 basis points to 2.75 percent.

Analysts expect more to come in 2011 as the Chinese authorities battle to keep a lid on inflation, which hit a 28-month high of 5.1 percent in November.

Our economists had expected a rate rise before the end of the year, but releasing the news on Christmas Day itself came as a little surprise to the market, said Chen Xin Yi, associate vice president at Barclays Capital in Singapore.

Nevertheless, we believe that the well-calibrated timing reflects consideration for minimizing unwanted financial market volatility and reducing potential capital movement to the extent possible.

Asian shares excluding China bucked the downward trend.

The MSCI index of Asian stocks outside Japan rose 0.1 percent with Japan's Nikkei closing up 0.75 percent, extending its recent outperformance in Asia.

U.S. stock index futures pointed to a lower open on Wall Street, with futures for the S&P 500 down 0.43 percent and Dow Jones futures down 0.36 percent at 1025 GMT.

China's central bank took aim at inflation once again on Monday by saying prudent monetary policy would be helpful in combating price pressures and asset bubbles.

Hu Xiaolian, a deputy governor, said China had been normalizing policy and will explore new ways to manage excess cash, which is seen as a major driver behind inflation.

AUSSIE DOLLAR STEADIES, EURO EDGES UP

The Australian dollar steadied, having been knocked by China's move. Australia has benefited from strong Chinese demand for iron ore and other commodities.

There was a knee-jerk sell-off in the Aussie but investors knew this China move was coming eventually. Providing the Chinese data holds up in 2011, the Aussie should stay supported, said Geoffrey Yu, currency strategist at UBS.

The Aussie dollar fell as low as $0.9987 before recouping losses to trade at $1.0039 in European trade.

The euro edged higher against the dollar in low volume trade with London markets shut Monday and Tuesday, while the yen hit a three-week high versus the greenback.

Commodity markets were resilient.

Spot gold regained lost ground after prices dropped about one percent in early trade in response to China's rate rise. Gold fell to a one-week low of $1,371.10, before recovering to $1,383.68 by 1025 GMT.

Oil climbed to a 26-month high as a blizzard in the U.S. Northeast offset uncertainty over Chinese fuel demand.

(Editing by Ruth Pitchford)

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