The Nikkei average pared losses after tumbling to an 8-month low on Tuesday as riskier assets were sold on a lack of progress in U.S. and European debt problems, but investors said the index may still fall to depths plumbed in the wake of the March earthquake.

The Tokyo Stock Exchange and Osaka Securities Exchange Co Ltd announced they would merge to create the world's third-largest bourse, sending shares in the Osaka bourse higher.

Market participants said there was reluctance to push prices down further ahead of a Japanese holiday on Wednesday but that amid overseas debt woes, risks were firmly on the downside and a test of the March 15 low of 8,227 was in sight.

Strategists also noted that the broader Topix has already broken through its post-quake low.

It wouldn't be surprising for the Nikkei to break below its March 15 low after the holiday if New York and Europe drops and there is more really negative news, said Toshiyuki Kanayama, senior market analyst for Monex Inc.

The Nikkei dropped 0.4 percent in thin trade to 8,314.74 after earlier falling as low as 8,261.01, well below support at the Oct. 5 low of 8,343.01.

But the broader Topix index added 0.1 percent to 717.79 after earlier falling to a new two-and-a-half-year low of 709.86.

In the United States, a bipartisan deficit-reduction committee admitted defeat on Monday and abandoned a three-month effort to find $1.2 trillion in budget cuts.

Concerns also mounted about Europe's debt crisis, with Moody's saying a recent rise in interest rates on French government debt and weaker economic growth prospects could be negative for France's credit rating.

THIRD-LARGEST BOURSE

The Osaka bourse jumped 4.6 percent to 440,500 yen after the announcement of the long-negotiated deal but remained below the Tokyo bourse's offer price of 480,000 yen.

The new exchange is set to start up in January 2013. The combined value of stocks listed on the exchanges would trail only NYSE Euronext at $12 trillion and Nasdaq OMX Group Inc at nearly $4 trillion, figures from the World Federation of Exchanges show.

Still, the new exchange lacks a convincing international strategy, seen as an important factor for growth since its home market is mired in deflation and has suffered years of economic stagnation.

Shares in troubled Olympus Corp jumped 19.9 percent at 869 yen, up for a second day in a row. Olympus said on Monday a third-party panel it appointed to look into the accounting scandal at the firm has so far found no connection between M&A funds and organised crime syndicates.

Embattled tissue maker Daio Paper Corp advanced 7.2 percent to 546 yen on hopes that it is on the way to putting its accounting scandal behind it.

Jiji news agency reported on Tuesday that prosecutors arrested Mototaka Ikawa, Daio's former chairman, who is suspected of diverting billions of yen from subsidiaries and using the funds for personal use. [ID:nL4E7MM0AD}

The stock has gained nearly 26 percent since Nov. 11, when it plunged 18 percent after the Tokyo bourse put it on its supervisory list.

Itochu Corp edged up 0.4 percent to 755 yen after sources told Reuters private equity firm KKR & Co had brought in the Japanese trading house in its $7 billion bid for U.S. oil and gas company Samson Investment Co.

The deal, with an enterprise value of over $7 billion, would be one of the largest private equity transactions of the year globally.

Volume was thin with 1.51 billion shares changing hands on the main board, a slight rise from the 1.23 billion shares on Monday.

Advancing stocks outnumbered declining issues, 857 to 643