TOKYO -- When foreign investors swept back into Japan's equity market last year despite the grim state of the economy, the popular justification was among the simplest: The economy, investors reckoned, couldn't get much worse.

Japan, after all, had been through the economic ringer. After a dazzling go-go market of skyrocketing stock and property prices, the world's second-largest economy stumbled onto hard times. It stagnated for much of the 1990s, dipping into two recessions in the past six years. Unemployment rose to record levels. The central bank guided nominal interest rates to the lowest level recorded in financial history: zero for all practical purposes.

With the benchmark

Nikkei 225

at less than half its peak and with rates so low, why not buy Japanese shares, money managers asked themselves. Asset values have nowhere to go but up, right? Foreign investors poured 9 trillion yen ($85.7 billion) into Japanese assets in 1999, according to the

Tokyo Stock Exchange

. That money alone would have moved the market higher. But with the U.S. markets corkscrewing higher, even the Japanese got equity happy and pushed the Nikkei up 37% last year. Foreign money managers did even better; the average Japan fund rose 113% in 1999, according to fund tracker

Morningstar

.

Since, macroeconomic statistics have shown a broad-based improvement. Capital spending is rising. Sales of electronics are surging. Corporate profits, which the statistic equity investors are most interested in, are better than expected. This year's numbers are backing up last year's theory.

All of that has investors pondering when the

Bank of Japan

will raise rates and what the effect of higher borrowing costs will be on the economy. Many think the trigger for higher rates could come Tuesday when the central bank releases a quarterly business-sentiment survey that is more widely watched than many of the country's harder economic data. The survey, known as the

tankan

, is expected to show that corporations big and small are now more optimistic about the general state of affairs.

"The June tankan will show capital investment will rise in fiscal 2000," says Peter Morgan, senior economist at HSBC Securities. "And that's positive for the stock market."

Buying on rising rates might seem counterintuitive. Cynics might even argue that it's unreasonable. But in Japan, where borrowers have been known to go to high-interest lenders in order to maintain relationships, the illogical often makes sense. The rationale Bank of Japan Governor

Masaru Hayami

is said to be employing is that higher rates will force corporations to continue restructuring. Hayami has made a career of threatening higher rates recently. Maintaining low rates, he worries, will give executives the wiggle room to avoid making the tough decisions -- firings, plant closings, etc. -- that the behemoths of the country need to make.

And that is good news.

"I believe that once there is greater conviction regarding restructuring and sustainability of an earnings expansion, there is scope for a resumption in foreign buying later in the year," says Kathy Matsui, chief strategist at

Goldman Sachs

. Matsui, who cautions that higher rates may initially be met with some selling, expects the

Topix

index, a broad measure of equities that is roughly analogous to the

S&P 500

, will rise at least 13% to 1800 over the next 12 months.

Some economists expect rates to rise 25 basis points as early as July 17, when central bankers meet. Even though that would only bring the overnight rate, the rate banks charge each other for overnight loans, to 0.25%, three influential central bank economists suggest that's enough to kick Japan Inc. into gear. In a paper,

The Asset Price Bubble and Monetary Policy: Japan's Experience in the Late 1980s and the Lessons

, the bankers suggest the ultra-easy monetary policy could actually foster another bubble economy, surely something everyone wants to avoid. (The English-language version of the report can be found at the

Bank of Japan's Web site.)

More company discipline and the collapse of bad ones should help Japan funds, which haven't had as good a year in 2000 as in 1999. The average Japan fund has lost 12.9% this year, compared with the average U.S. mutual fund's 4.2% rise, according to Morningstar. A few examples include

Fidelity Investment's

(FJPNX) - Get Report

Japan Fund, down 13.8%, and the

(GAJCX)

GAM Japan Capital Fund, down 9.8%.

The one irksome factor, according to HSBC's Morgan, is if the Bank of Japan gets carried away and continues to put the monetary screws on corporate Japan. It could choke the just recovering economy, he says.

"The BOJ is trying to send a pretty clear signal that its rate hike will be quite limited and that policy will remain easy for some time," Morgan says. "Let's just hope

they are right."