* Europe debt woes roiling financial markets
* Economic impact on Japan limited so far but govt still wary
* Govt repeats pledge to work with BOJ to end deflation
* Japan yet to regain self-sustaining strength - Kan (Adds Naoshima comments)
By Stanley White
TOKYO, May 24 (Reuters) - Japan's economy is picking up steadily but Europe's debt crisis, wild swings in financial markets and deflation pose risks to its outlook, the government said on Monday.
Finance and Economics Minister Naoto Kan said that while the direct impact of Europe's debt problems on Japan's economy was limited, he was closely watching the situation in the region.
In its monthly report for May, the government kept its assessment of the economy unchanged for the third straight month as capital expenditure bottoms out on increases in exports and output.
But it added a phrase to the May report warning about Europe and financial markets, as the region's debt crisis sparked fears of sovereign risk and caused global stock markets to tumble.
"Attention should be paid to potential risks to Japan's economy such as a possible slowdown in overseas economies, particularly in Europe, fluctuations in financial markets and the influence of deflation," the report said.
Japan's economy grew 1.2 percent in the first quarter, the biggest expansion in three quarters, on robust exports to Asia, although analysts expect growth to slow as consumption begins to lose support from government stimulus measures.
"The recovery has been largely driven by external demand and economic stimulus measures. I can't say that the economy is on track for a self-sustaining recovery yet," Kan told reporters after a meeting of ministers to approve the report.
The government's assessment of the economy roughly matches that of the Bank of Japan, which upgraded its view to say last week that the economy is starting to recovery moderately.
The euro skidded to an 8 1/2-year trough versus the yen last week as the euro zone's 750 billion euro ($942.8 billion) safety net for the debt obligations of its members has failed to ease concerns about weak public finances.
The yen also rose against the dollar, prompting a warning by Japan's finance minister on Friday that excessive currency moves were undesirable. A strong yen hurts Japanese exporters by making their goods less competitive overseas.
Trade Minister Masayuki Naoshima also warned on Monday that weakness in euro-zone economies may affect Japan's recovery if its key export destinations in emerging Asia take a hit.
"Japan is vulnerable to currency risks and therefore we need to closely watch such risks," Naoshima said, according to a government official present at the meeting.
The government stuck to the view that Japan is in mild deflation and repeated its call for the central bank to support the economy through appropriate and flexible policy.
Since the government first declared in November that Japan was in mild deflation, the BOJ has eased policy twice and said it will not tolerate zero inflation.
The BOJ kept monetary policy unchanged in a meeting that ended on Friday but outlined a new loan scheme targeting growth industries, which it described as a long-term approach to beating deflation. ($1=.7955 Euro) (Additional reporting by Tetsushi Kajimoto; Editing by Michael Watson)