Feb. 14 (Bloomberg) -- Japan's economy grew 3.7 percent last quarter, twice the pace economists forecast, as business investment rose and exports to Asia helped companies weather the U.S. slowdown.

Gross domestic product in the three months ended Dec. 31 accelerated from a 1.3 percent expansion in the third quarter, the Cabinet Office said today in Tokyo. The median estimate of 39 economists surveyed by Bloomberg News was for annualized growth of 1.7 percent.

The Nikkei 225 Stock Average surged the most in six years after the report and an unexpected increase in U.S. retail sales allayed concern that the world's two biggest economies may slip into a recession. Bonds fell as investors pared bets that Governor Toshihiko Fukui's successor at the Bank of Japan will have to cut interest rates.

``The person happiest with this data has to be Mr. Fukui,'' said David Cohen, director of Asian forecasting at Action Economics in Singapore. ``This certainly suggests that as long as the whole world doesn't go over the edge, Fukui's model of continued, modest growth is still valid.''

The chance of a rate cut by December fell to 31 percent after the growth report from 47 percent, according to calculations by JPMorgan Chase & Co. Economists predict Fukui will hold the key rate at 0.5 percent tomorrow at the end of his second-to-last policy meeting. Fukui's term expires March 19.

The Nikkei rose 4.3 percent to 13,626.45, its steepest gain since March 2002. The yield on Japan's 10-year bond rose 5 basis points to 1.465 percent.

U.S., European Growth

Japan, the world's second-largest economy, expanded 0.9 percent from the previous quarter. Growth in the U.S., the country's biggest market, slowed to 0.2 percent from 1.2 percent in the same period. The European Union probably grew 0.3 percent in the fourth quarter, less than half the pace of the previous three months, economists expect a report to show today.

Net exports -- or the difference between exports and imports -- contributed 0.4 percentage point to growth. Exports rose 2.9 percent from the previous quarter, as record sales to Asia countered waning demand from the U.S.

Sales at Toyota Motor Corp. and Canon Inc., the country's biggest makers of cars and cameras, rose in the three months to Dec. 31 as demand from emerging markets increased.

``The U.S. still matters but there's a more balanced source of demand than there was 10 years ago,'' Cohen said. ``That's a reason not to be too pessimistic about Japan.''

Corporate Investment

Rising demand from Asia, Russia and the Middle East encouraged companies to increase spending on factories and equipment. Capital investment rose 2.9 percent in the fourth quarter, accounting for about half of growth in the period. Economists had expected a 0.9 percent increase.

``Yes, companies are worried about the U.S., but they're still investing,'' said Jan Lambregts, head of Asia research at Rabobank International in Hong Kong. The Bank of Japan's quarterly business survey showed companies planned to increase spending and ``this confirms that people are putting their money where their mouths are.''

Still, other reports suggest companies are bracing for a slowdown. Machinery orders fell for a second month in December. Manufacturers plan to cut production in January and February, the Trade Ministry said last month.

``I am concerned about weak domestic demand,'' Japanese Prime Minister Yasuo Fukuda, said in a regular meeting with reporters in Tokyo. ``However, led by overseas demand and output the economy is taking steady steps.''

U.S. Slowdown

Economic and Fiscal Policy Minister Hiroko Ota said today that ``downside risks'' for the economy are rising and a slowdown in the U.S. will eventually affect exports.

Omron Corp., a maker of factory sensors and a supplier of parts to Nissan Motor Co., last month cut its sales forecast for the year ending March 31, citing a drop in domestic orders for sensors used to automate assembly lines. Advantest Corp., the world's biggest maker of memory-chip testers, slashed its sales outlook 22 percent after clients reduced orders.

The economy continued to suffer from a construction slump. Housing investment fell 9.1 percent last quarter because of a permit logjam caused by government rules designed to stop building fraud.

Housing starts plunged in the six months since the rules were introduced in June. The latest figures show that the drop in starts is slowing and the industry is making up lost ground.

``A recovery in the construction sector could add half a percentage point to GDP growth in 2008,'' said Julian Jessop, chief international economist at Capital Economics Ltd. in London. ``That's enough to counter a smaller contribution from trade. The big unknown is the consumer side.''

Consumer Spending

Private consumption edged up 0.2 percent from the previous quarter, less than economists' expectations of a 0.3 percent gain. Reports show spending may weaken.

Household sentiment slumped to the lowest level in more than four years in January as falling wages and rising prices eroded spending power. Applicants outnumbered job offers for the second straight month in December.

Rising oil prices may have boosted growth in real terms. The GDP deflator, a broad measure of prices used to calculate real growth from nominal, fell 1.3 percent from a year earlier, the biggest drop since the first quarter of 2006. The deflator is adjusted downwards when oil prices rise. In nominal terms the economy grew an annual 1.2 percent in the fourth quarter.

The GDP figures are preliminary and will be revised on March 12.

To contact the reporter on this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net

Last Updated: February 14, 2008 05:26 EST