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Alex Shifrin thought he found a surefire way to profit from Moscow's new consumers with an old Russian tradition: soup. Russians can't get enough of the stuff, slurping down an incredible 32 billion bowls each year. But with the city's emerging middle class increasingly adopting Westernized, on-the-go lifestyles, soup fans have less time to boil it for themselves. Shifrin, an advertising executive, and three partners smelled an opportunity. Why not cook it for them? They pooled their personal savings and in April 2010 launched Soupchik, a chain of takeaway outlets serving up borscht, chicken noodle and other local favorites to upwardly mobile Muscovites.

The investors, however, learned that nothing in Russia is a sure thing, thanks to the unpredictable and predatory government. A steady stream of corrupt tax officials, police officers and other security agents began harassing them for payoffs. Within weeks of Soupchik's opening, two tax inspectors claimed the start-up was violating an obscure retailing regulation. Shifrin protested, and amid the negotiations, a tax administrator suggested that some $1,000 in cash would resolve the matter. (Shifrin refused to ante up, and the tax office eventually dropped its case.)

Matters got worse later in 2010 when eager bureaucrats declared war on shops like Soupchik after Moscow's mayor remarked that the numerous stalls dotting the city were unsightly. One day in October, an employee at a Soupchik kiosk phoned the head office in a panic: bulldozers were outside, poised to flatten the shop. A manager rushed over in a van to rescue the kitchen equipment before the kiosk was smashed into rubble. New regulations made accessing sidewalk space for more Soupchiks extremely difficult. The chaos forced the investors to overhaul their business model. Instead of stand-alone kiosks, they opened all but one of their six outlets inside modern shopping malls — an attempt to shield them from bureaucrats hungry for bribes, not borscht. Doing business in Russia is "a moving target. There are no real rights," Shifrin says. "If you could put your $100 million in any market, why would you put it here?"

That's a question more and more businesspeople are asking. Before the Great Recession, Russia was one of the world's premier emerging markets. Economic growth was stellar, at more than 7% a year from 2000 to 2007. Rising incomes created a lucrative market for consumer goods like cars and refrigerators. Foreign investors rushed in for a piece of the action. Goldman Sachs bunched Russia with Brazil, India and China as the BRICs, the four large developing economies the bank considered best positioned to dominate global growth for decades. After falling so low after the 1991 collapse of the Soviet Union, Russia was again asserting itself on the world stage, backed by both military might and economic progress.

Not anymore. While the other BRICs have shrugged off the recession and soared to new heights of global influence, Russia has not regained its precrisis moxie. With the economy plagued by sluggish growth and anemic investment, the outlook has turned gloomy. Neil Shearing, senior emerging-markets economist at research firm Capital Economics in London, forecasts that Russia could average only 3% annual growth over the next 15 years — a pittance compared with the stratospheric rates notched by China and India. "The old growth model has broken down," he says.

That could have serious consequences for both Russia and the West. Prime Minister Vladimir Putin, the country's uncrowned czar, has linked his legitimacy to the economy's performance by offering the Russian people a grand bargain: submit to his increasingly autocratic rule and the state will compensate with economic goodies like higher incomes and hefty social-welfare spending. Now that the economy is faltering, Putin is under intensifying pressure from a discontented public to restore Russian democracy, potentially destabilizing Russian politics. He has already faced protests in Moscow against his rule amid the economic downturn. There's also a risk that leaders in Moscow will resort to nationalistic appeals to distract the public from problems at home, escalating tension with Russia's neighbors, the rest of Europe and the U.S. Putin even now has a testy relationship with Washington. After the recent debate over the U.S. debt ceiling, he accused Americans of "living like parasites" on the global economy. "A faltering economy is more likely to produce an aggressive and adventuresome [Russian] foreign policy," says Charles Kupchan, a senior fellow at the Council on Foreign Relations in Washington.

The Politics of Pillage
what's gone wrong? the problems are rooted in the structure of Russia's economic model. After a tumultuous decade in the wake of the Soviet demise, which featured an embarrassing 1998 government default, Putin took over in 2000 and re-established the state's dominance in the economy. He wrested control of large swaths of Russian industry from the handful of oligarchs who had taken advantage of the disintegration of the Soviet command economy to build massive business empires. Lubricated by oil revenue, Putin lavished spending on state welfare programs, sparking a consumer boom. Russia was even lauded by some economists for its model of state capitalism, which has at times appeared superior to the more laissez-faire systems of the West, particularly in the immediate aftermath of the financial crisis.

Now, however, state capitalism is strangling Russia. Government-owned companies, shielded from competition, are crowding out private enterprise. Over the past seven years, the government has gobbled up private players in the crucial energy sector, with Rosneft, the state-controlled oil giant, and Gazprom, the natural gas monopoly, becoming two of the largest energy companies in the world. The government owns about half of all shares in companies listed on the Moscow stock exchange, up from 30% eight years ago. As a result, says Arkady Dvorkovich, an economic adviser to the somewhat more reform-minded President, Dmitri Medvedev, the performance of the entire economy has suffered. "With state control, state companies enjoy a better position in the market," he says. "They don't have motivation to improve efficiency and the quality of goods and services, and this affects the whole market." The number of public-sector employees exploded under Putin, growing by nearly 80% to more than 868,000 in 2009, without much improvement in services. With more bureaucrats, there are more sticky fingers grabbing at entrepreneurs like Shifrin. In its 2010 corruption-perception index, Transparency International ranked Russia well below the other BRICs and behind even Zimbabwe, Haiti and Pakistan. "Russia has 140 million hardworking people and 1 million people who want to steal from them," says William Browder, CEO of Hermitage Capital Management, a London-based investment fund.

Browder should know. The American-born financier has been at the center of one of several high-profile controversies that have exposed parts of the Russian bureaucracy as something akin to an organized-crime family. Once the largest foreign portfolio investor in Russia, he created a stir by confronting corporate managers over shady dealings. That led to his banishment from the country and a scam in which, Browder claims, government officials used his corporate documents to steal $230 million in tax revenue. One of his lawyers died suspiciously while in pretrial detention. (The Russian government is investigating the death, as well as a tax-evasion case against Browder.)

Billionaire Alexander Lebedev, who controls the National Reserve Bank and the country's most popular opposition newspaper, has publicly accused a cabal of police and secret-service agents of seeking to seize his assets through an intricate conspiracy, which he has linked to recent police raids at his offices, intimidation of his staff and alleged demands for multimillion-dollar bribes. Earlier this year, he wrote an open letter to Putin appealing for an investigation of these "werewolves in epaulets." Without curtailing corruption and strengthening the legal system, Lebedev says, Russia can't compete with China or India. "The political system here is an impediment to economic growth," he says. "You can hardly find an aspect of life that cannot be explained by the huge dominance of corruption at the highest echelons. It has come to the point that it couldn't get worse."

Actually, it could. The corrupt and intrusive state is scaring off what the Russian economy needs most: investment. Over the past six quarters, a net $65 billion of private capital flowed out of the country. Without that cash, Russia can't spur growth, rebuild decrepit infrastructure, upgrade its industrial base or create jobs for college graduates. In a March speech, Medvedev admitted that the investment climate "is very bad, very bad" and corruption had "a stranglehold" on the economy. "We cannot let this situation continue," he warned.

The Market Fights Back
that pledge has led to a rethink of Russia's economic model at the highest levels of policymaking. Those who admire state capitalism "don't know what they're saying," says Dvorkovich. "This way of doing things has exhausted all its potential, so we need to change policies." A flood of market reforms has rushed from the Kremlin, including proposals to eliminate regulations, reduce controls on foreign investment, shrink the bureaucracy and improve the transparency of state companies. In early August the government announced it would sell off majority stakes in a wide range of state-owned enterprises by 2017. "I want to state loud and clear here that we are not building state capitalism," Medvedev said in June.

Yet so far, Medvedev's bold talk has remained mostly talk. In part, the roadblock may be a resistant bureaucracy still not detached from its Soviet roots. "There is no respect for private property and economy in the minds of the majority of bureaucrats," Dvorkovich complains. The biggest obstacle might be Putin. Medvedev sits in the Kremlin, but Putin remains the ultimate arbiter in the economy, and there is little to suggest he has joined the small-government tea party. "He believes in the traditional Russian way — the state should be the biggest player in everything," says Maria Lipman, a political analyst at the Carnegie Endowment for International Peace in Moscow. The sort of liberalization propounded by Medvedev would threaten the sources of patronage and control that ensure Putin's position. In fact, by advocating market reform, Medvedev and his advisers are issuing a barely veiled critique of Putin. Dvorkovich talks of turning Russia into a "less paternalistic" society — a swipe at Putin's method of governing: "I think we have, potentially, people who are more inclined to freedom than state intervention into private life." And, Dvorkovich adds, their numbers are growing. Yet more paternalism is likely what Russia will get. With the next presidential election in March, Kremlin watchers are waiting to see if Putin will declare his candidacy for a third term.

Because of his popularity at home and the not-so-free-and-fair nature of Russian elections, he would almost surely win. Even if Putin remains in the background, some analysts believe Medvedev and his team haven't forged a political base sturdy enough to challenge Putin or his policies. That leaves Putin's critics convinced that only a major shake-up in Russian politics could fix the economy. Talk of market reform "is like a patient with terminal cancer putting on nice makeup," says Browder. "In order for Russia to change, they need a real change in most of the government leadership."

Diversify or Die
with no sign of that happening, discontent is growing. In a closely watched August poll conducted by Moscow's Levada Center, a mere 22% of respondents believed their government could improve the country's prospects. A restless public is not the only factor increasing the pressure to reform. The poor investment climate has made the economy dangerously dependent on oil and more vulnerable to volatile prices. Putin's expanded state is so thirsty for oil revenue that it requires not just high prices but increasing prices to meet its spending commitments. If oil prices plunge to $70 or less per barrel, it could face a budget crisis. The only solution is diversification into new industries, but Russia has had minimal success. Even though it was famous during the Soviet era for its advanced technical talent, the country today has only a handful of technology firms with a global presence.

The Kremlin is attempting to change that through — not surprisingly — state action. Medvedev has endorsed a $6 billion program to create a state-run technology park outside Moscow called the Skolkovo Innovation Center. Companies that gain admittance will get tax breaks, express customs clearance and other perquisites. Some 120 firms have received the green light so far. Yet even the endeavor's senior managers fret that the program will be undermined by corruption. To shield the project from self-serving bureaucrats, applications are judged by panels of independent experts. Plans call for the park, on which construction is just beginning, to have special teams of police, health inspectors and other government agents to ensure that the usual suspects don't prey on the start-ups. Alexey Sitnikov, head of international development at the Skolkovo Foundation, the organization managing the project, hopes that a successful park will kindle the entrepreneurship the nation so badly needs. The goal "is not so much diversifying the economy but creating an entirely new economy," he says.

Is that possible? One factor that still binds Russia to China, India and Brazil is its tremendous untapped potential in the still strong consumer market. Car sales, for example, jumped 32% in August from a year earlier. It is telling that Alex Shifrin refuses to give up on Soupchik even after the trauma he has endured. "Russia is a lousy place to do business," he says, "but a great place to make money." Unfortunately, with the state in the way, not enough businesspeople are willing to find that out.

—with reporting by Simon Shuster / Moscow

• Michael Schuman / Moscow
• Corruption is driving out entrepreneurs and strangling the economy. Can the Russian miracle continue without reform?