China stocks at 3-1/2 mth low, Hong Kong breaks below 200-day MA

* Shanghai Comp drops 3 pct, tight liquidity weighs

* Hang Seng breaks below 200-day MA, more weakness seen

* Turnover in HK remains muted, no sign of panic: traders

* Milan Station shoots up 65 percent on debut (Updates to close)

By Vikram Subhedar and Clement Tan

HONG KONG, May 23 (Reuters) - China shares fell to a 3-1/2-month low on Monday, dragging Hong Kong lower, as retail investors piled into a selloff after a spike in money market rates and a softer reading on Chinese manufacturing suggested more weakness ahead.

Earlier on Monday, China's benchmark money market rate , the main barometer of availibility of short-term funds, jumped 64.5 basis points as traders expect a liquidity squeeze to continue at least until the end of this month, potentially limiting banks' lending activity. [ID:nL3E7GN0BC]

The benchmark Shanghai Composite Index finished almost 3 percent lower at 2,774.6 points, its biggest daily loss in more than four months, after trading in a narrow 30-point range for the previous eight sessions.

Hong Kong's Hang Seng index dropped 2.1 percent, breaking below its 200-day moving average, currently at 23,007, that had largely held firm this year and is now seen as near-term resistance for any bounce.

"We're now in a down trend for sure, but the dip today seems a little excessive," said Zhang Qi, an analyst with Haitong Securities in Shanghai. Traders said panic selling by retail investors probably magnified the losses.

Heavyweight financial and energy counters were the largest drags on the composite index as Industrial and Commercial Bank of China Ltd and China Shenhua Energy Co Ltd lost 1.8 and 3.1 percent, respectively.

PetroChina Co Ltd lost 1.9 percent as U.S. crude prices fell below $100 per barrel amid a rally in the dollar as worries about the euro zone debt crisis escalated.

Monday's loss pushed the stock back in into technically oversold territory, where it has been for most of May. It is now down 10.8 percent since hitting its 2011 peak in mid April and down 8.7 percent this quarter.

Analysts said concerns about China's slowing growth also weighed on the market after the HSBC flash manufacturing purchasing managers' index (PMI) showed Chinese factories expanded in May at their slowest pace in 10 months while prices pressures eased, adding to evidence that the economy is moderating as a tighter policy starts to bite.

Data showed the flash PMI eased to 51.1 in May, the lowest since July 2010, but still on track for expansion as a reading above 50 points to growth.[ID:nL3E7GN06N]

"Today's flash PMI is renewing concerns that the government's attempts to fight inflation might be overly aggressive and lead to growth that might be slowing too much," said Cao Xuefeng, head of research at Huaxi Securities.

HK FOLLOWS CHINA DOWN, NO PANIC SEEN

In Hong Kong, turnover rose from Friday's thin levels but remained about 4 percent below the average volumes seen over the past 20 sessions, suggesting market players were not rushing for the exits.

"There's certainly some concern out there but no real evidence of people bailing out," said Tom Kaan, a director at Louis Capital Markets in Hong Kong.

"It seems to me that a lot of the proprietary trading desks are chucking out some of their longs and putting on some shorts but cash volumes remain low," said Kaan.

Losses in Hong Kong were led by a 1.9 percent dip for HSBC Holdings , Europe's biggest bank, followed by ICBC , which fell 2.7 percent. and China Construction Bank , which slid 2.1 percent.

HSBA has a 15 percent weighting in the benchmark index,

Commodity-related counters also fell as crude oil prices retreated by as much as $2 a barrel.

Shares of oil major CNOOC fell 1.5 percent and were the top drag on the benchmark following the financials. Petrochina shed 1.9 percent.

Retail issues were among the weakest in the Hong Kong market, led by top consumer goods exporter Li & Fung Ltd , which fell 4.6 percent and was the top loser on the main index. Li & Fung previously traded under the listing code 0494

"It remains an interesting and well-managed company but I think market expectations were just too high," said Matthew Marsden, China consumer analyst at Samsung Securities, who was rated the most accurate earnings forecaster for the company according to Thomson Reuters Starmine.

Li & Fung, which resumed trading after a 1-for-2 stock split last Thursday, is trading at 23.3 times its forward 12-month earnings forecast, a 3 percent premium over its long-term median valuation, according to Starmine.

Bucking the weaker trend in the market, Milan Station , a retailer of second-hand handbags, shot up 65 percent on its trading debut as investors who were not allocated shares in the heavily subsribed issue rushed in to buy. The issues was oversubsribed over 2,000 times.

(Editing by Kevin Plumberg & Kim Coghill)