China is in the throes of a stock-market frenzy that looks increasingly unsustainable.

Chinese stocks have nearly sextupled in value in just two years and set yet another record yesterday, when the benchmark Shanghai Composite Index catapulted above 6000 for the first time.

Big unknowns remain. Is this a bubble, and, if so, will it end with a bang or a whimper? And if it ends in tears, what will the bubble have wrought?

The first questions are unanswerable, of course. But there is strong evidence that even if the boom ends in havoc, as bubbles often do, China’s investing frenzy will also leave behind much lasting good. The boom is helping build a modern, market-driven financial system.

From glitzy Shanghai to gritty industrial centers like Wuhan, tens of millions of Chinese have poured substantial savings into stocks. As a result, China suddenly has a stock market that is as powerful as its economy, now the world’s third-largest. That is an astonishing turnaround for a system considered beyond repair three years ago.

The $3.7 trillion value of stock listed on China’s Shanghai and Shenzhen exchanges at least equals the size of the country’s annual economic output, a level historically seen in the U.S. This year, China’s markets have had the world’s highest volume of shares traded and are on track to raise the most money of any exchanges through stock offerings.

The flood of investment is producing some potentially far-reaching benefits. For the first time since China’s economic overhauls began almost 30 years ago, money from the investing public — instead of the Communist Party — is fueling expansion of the corporate sector. The boom is helping to create a class of Chinese companies among the most valuable in the world and spawning a financial-services industry that is even helping foreign firms, such as Prudential Financial Inc., based in Newark, New Jersey.

Yet China now faces a classic challenge: how to reap the benefits of a boom while avoiding a crash that could stall its economic progress.

There is an increasing sense that the stock market is heading for trouble. The Shanghai Composite Index closed up 2.2% Monday at 6030.09. A year ago, it was below 2000 and has more than doubled this year.

‘It’s like a bubble, but no one knows when it will pop,’ says Stephen Guo, a 27-year-old Shanghai computer programmer who last year started making more money trading stocks than in his day job. Now, just two years after he entered the market, Mr. Guo is also managing the investments of his friends, a risky strategy that promises to spread the pain if the market sharply reverses.

The rush of investors into stocks is sowing fears about an epic market crash, the kind that followed historic bubbles in places such as the U.S., Japan and Taiwan. The question increasingly is whether a steep drop in stocks would wipe out the burgeoning investor class and what impact that would have on China’s economic transformation. Stock markets in China are dominated by as many as 50 million individual investors, who are responsible for about 70% of the trading. That is the reverse of Western nations, where big firms set the tone.

Once sentiment cools — as it inevitably will — some question whether China’s fundamental market improvements will endure.

‘Crises go with financial development,’ says Richard Sylla, an economic historian at New York University’s Stern School of Business. ‘The real question is whether they do lasting damage.’

Faced with signs of bubbles throughout the economy in recent years, China’s leaders, including President Hu Jintao, have repeatedly urged moderation. Such calls have done little to slow spending on factories, real estate — or now, stocks. Many Chinese investors say they are betting the government will do little to undercut shares at this week’s meeting of top Communist Party officials and that policy makers want the market to remain strong through the Beijing Olympic Games next August.

Trading on the Internet nearly every day before work, Mr. Guo studies corporate reports and watches technical trends before buying. His main plays have been blue-chip stocks. When the Shanghai Composite Index dropped 8.8% in February, Mr. Guo pumped $4,000 into the market — only to see the index double since then.

The more Mr. Guo has profited, he admits, the more he has become comfortable introducing risk to his strategies. And his decision this year to take on co-investors could get him into trouble if the market reverses, partly since some of them used money borrowed from their credit cards. ‘The friends trust me,’ he says.

As an investing culture takes hold in China, many are adopting more-sophisticated trading strategies, but few have the experience to know when they have gone too far. On a recent night in Hangzhou, about 2,000 Chinese paid $800 apiece to see American investing guru Jim Rogers dispense advice. He counseled caution, calling the market a ‘potential bubble’ that could spoil the party if left unchecked. ‘You have to be careful,’ he said. Still, one investor paid $53,000 the next night to talk stocks in a private dinner with Mr. Rogers.

History has repeatedly shown that bubbles can be dangerous. Yet often overlooked in the mess when bubbles pop are the real changes that initially drove the boom, fundamental improvements that often outlive the crisis.

After the 1929 stock-market crash helped plunge the U.S. into the Great Depression, economist John Maynard Keynes chided those who said economic downturn was a just outcome for excesses in the previous years. ‘While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched,’ he wrote.

China today looks like the U.S. of the 1920s to Marc Faber, a well-known money manager based in Thailand. He notes that just as Chinese investors are confident about their economy, the U.S. economy was surging on hopes about technological changes like the radio and the rise of a consumer class. ‘The stock market went ballistic because the prospects of the country were so favorable,’ says Mr. Faber.

Of course, the Great Depression was America’s worst-ever economic setback, and the Dow Jones Industrial Average didn’t fully recover until the mid-1950s. Yet, the crash itself resulted in the creation of basic investor safeguards that strengthened the market and probably limited fallout from later market tumbles.

In the 1980s, Japan and Taiwan had two of the hottest economies and stock markets anywhere. In 1986, Japan’s market even overtook America’s briefly to become the world’s biggest, according to Thomson Financial. A potent brew of conditions combined to supercharge the stock market in both places: rising land values, strong corporate profits and currencies, low interest rates, high savings rates and limited investment alternatives — factors all seen in China today.

In 1990, the markets cracked. Taiwan’s market dropped 79% in half a year. Japan entered a prolonged slump, with the Nikkei Stock Average bottoming out 13 years later at just a fifth of its peak value. Japan would have been better off without the economic pain that accompanied the crash. But the boom years that preceded the crash transformed Japan’s economy into one of the world’s largest and most sophisticated. And better policy making might have prevented the pain from being so prolonged.

More recently, the U.S.’s Nasdaq Composite Index remains under water since the popping of the technology bubble in 2000. Yet, many believe the tech bubble of the 1990s fueled innovation and the adoption of the Internet, and that its painful unwinding separated the strong from the weak.

If history is any indication, China’s stock prices, which are meant to reflect prospects for the companies listed on the market, signal potential problems. Chinese shares are expensive by almost any measure, including a price/earnings ratio of 69 times last year’s earnings on the Shanghai market. That ratio on the Standard & Poor’s benchmark index was 28 when U.S. markets crashed in 1929 and just 18 at the time of the 1987 plunge, according to Ativo Research LLC. Still, the Chicago-based advisory firm says P/E ratios peaked at 71 in Japan, 100 in Taiwan and 123 on the Nasdaq before those markets crashed.

The market could go higher still as millions of new investors continue to sign up. Merrill Lynch & Co. estimates only about 22% of Chinese financial assets are in securities, far less than the U.S.’s 52% level.

China’s prodigious savers traditionally kept their money in the bank. In August, Xu Shaosong, a pharmaceuticals salesman in Wuhan, plunked about a third of his bank savings, or $1,300, into the stock market. The 29-year-old had never invested before but says that over the past year he got restless watching friends make money.

Dressed in a peach shirt and khakis, Mr. Xu says he is concerned about the lofty level of stocks, but he and his wife want to have a baby soon, and he hopes to improve on the negligible return they earn on bank savings. It is a basic financial decision millions have made: Risk some money in a market that has risen nearly every month since mid-2005.

And rather than try to figure the market out on his own, Mr. Xu took a cautious route into equities: a mutual fund — one jointly managed by Prudential.

‘My knowledge and skills aren’t good enough to trade stock by myself,’ he says. Still, his small contribution helped Prudential’s 33%-owned Everbright Pramerica Fund Management Co. raise 1.8 times its target of $1.3 billion in a single day.

Recent history shows how China’s huge population of savers can quickly bring about deep economic change. Under communism, few Chinese owned their homes. When they were first offered the chance a decade ago, the property market was unsophisticated and legal protections were weak. Yet today, China has an 82% urban-homeownership rate and massive construction, real-estate and decorating industries. American homeownership, by comparison, has never topped 70%, according to the U.S. Census Bureau.

A similarly rapid shift is taking place in the stock markets, which the government opened in 1990 as an ‘experiment.’ The Shanghai and Shenzhen exchanges were choked with restrictions and poorly regulated, and trading came to be called ’stir-fying stocks.’ By the time a slump ensued in 2001, most Chinese had soured on stock investing.

In 2005, Beijing rebuilt its markets. It halted new listings for a year, offered financial support to brokerage firms as they restructured and beefed up trading systems. The government also junked old communist tenets, including a structure where two-thirds of the stock-market value was locked into a class of nontradable shares originally meant to guarantee government control.

The markets were essentially relaunched in 2006 and began offering investors a class of blue-chip stocks for the first time. The government encouraged a parade of big Chinese companies to sell stock at home instead of simply going to international markets, starting with famous names like Bank of China Ltd. and Air China Ltd. Seven of China’s 10 largest listed companies have gone public within about the past year.

Thomson Financial forecasts the Shanghai Stock Exchange and its counterpart in Shenzhen could lead the world in equity fund raising for a second year in a row in 2007, with initial public offerings that in less than two years have already totaled about $62 billion.

Already, the stock market is fast replacing Beijing as the source of funds for its biggest companies, including a banking sector that was until a few years ago drowning in bad loans. To fix behemoth Industrial & Commercial Bank of China Ltd., China’s government threw it a series of lifelines valued at tens of billions of dollars over the years, culminating in early 2005 with a $15 billion cash injection. Just over a year later, investors on the booming Shanghai exchange helped the bank raise $5.9 billion of its world-record $22 billion initial public offering. Now among the world’s most valuable banks by stock-market capitalization, ICBC has hit the acquisition trail, buying banks in Indonesia and Macau, and has plans for a New York branch.

Giant companies in other sectors, from shipping to insurance to steel, have used cash raised in markets to buy competitors and expand operations. One company emerging as a dominant business group is China Shenhua Energy Co., the three-year-old amalgamation of several Chinese coal mines. In its record-breaking IPO in September, the company raised $7.73 billion.

‘We have a more-perfect capital market today than three years ago,’ says Fang Xinghai, director-general of the government’s office of financial services in Shanghai. ‘The interests of the various types of shareholders are aligned.’

One missing element: foreign investors. A quota currently limits overseas money managers to owning about 1% of market capitalization, but, otherwise, money in the market is from domestic sources.

Yet, foreign firms like Prudential are making inroads. Half of the roughly 60 companies selling mutual funds to Chinese individuals are Sino-foreign joint ventures, while foreign banks like Citigroup Inc. also have offerings. So far this year, 45 mutual funds have raised about $54 billion, according to Shanghai’s Z-Ben Advisors Ltd. That averages $1.2 billion each, which would rank the typical Chinese fund among the top 22 launches ever recorded in the U.S. by Morningstar Inc.

A big question is whether China’s companies can ultimately deliver the stellar earnings performance that is predicted by high stock prices, says Robert Aliber, a professor at the University of Chicago’s Graduate School of Business. Profits of listed companies grew 74% in the first half of this year. But that number offers cold comfort, since some 38% of total net income was from companies’ own investment in the booming stock market — not their business, according to Shanghai Wind Information Co.

The Shanghai investor, Mr. Guo, says his buy-on-dips strategy should continue to pay dividends at least into next year’s Olympic Games. Although he thinks prices are already high, he says millions more investors will discover the market before the rally winds down.

If the market reverses, he will share the pain with his friends, he says. ‘According to our agreement, I have to bear some of the losses,’ he says. ‘But so far, I haven’t lost.’

James T. Areddy