Most people know the largest economy and most widely held currency in the world are in trouble, says spy-turned-newsletter-editor Fitzroy McLean.

As Byron King said recently in Penny Sleuth, the Bush administration has presided over a massive expansion of government’s role in finance - a new era of bailouts.

These bailouts will have a disastrous long-term effect on the dollar. Fitzroy recommends two currency plays to best protect your portfolio from the buck’s ultimate devaluation…

With declining tax revenues in a down economy, governments around the world have been stepping up to recklessly spend more, usually borrowing from the haves and giving it right back to them in interest payments or proceeds from importing their wares.

There’s one problem though, at least for the U.S.: The Financial Times recently reported that Arab and Asian funds are cutting their exposure to the U.S. dollar.

Can’t really blame them. For years they had been buying U.S. debt and recently switched to ownership: real estate, public equities, etc. But their cash infusions from private capital injections over the last twelve months have withered as the market value of major financial stocks continues to deteriorate. At this point, there is little course of action remaining other than to continue deflating the value of the currency by printing more money.

So, many developing markets are experiencing significant inflation because of a surge in foreign investment (which normally has the effect of driving up wages and asset prices), as well as rising commodity prices.

Even though commodities are generally priced in USD, many developing markets historically peg their currencies to some multiple of the dollar, so they feel the inflationary effects of rising corn, wheat, and oil as well. De-pegging would usually cause their currencies to strengthen against the dollar, mitigating the inflationary effects of rising commodities prices. Sounds great in theory, but many developing markets have been focusing on pro-growth policies, allowing inflation as a necessary evil. In our view, this trend is changing rapidly.

As we have discussed earlier, it doesn’t take too many riots for governments to give in and ‘do something.’

Unfortunately, this has historically been a far cry from actually ‘accomplishing something’ because, after all, you can always blame the other political parties.

Our assessment, however, is that the great constituency is growing impatient, and as family budgets around the world are stretched thin in the face of a myriad of other challenges (real and perceived) like climate change, energy scarcity, and population growth - governments will eventually adopt freer market policies with long-term benefits.

Argentina’s recent decision to eliminate export taxes for agricultural products is an indication of this trend, even in a highly leftist regime. China’s reduction of fuel subsidies is another.

The great shift in defending against inflation will likely culminate in many developing markets abandoning their dollar pegs and floating freely.

Last year, Kuwait and China broke away from their strictly USD pegs in favor of a basket of currencies which includes the euro, yen, pound, ruble, South Korean won, Thai baht, Aussie dollar, Canadian dollar, and Singapore dollar. Kuwait has been the most hawkish of the GCC about the dollar, at least publicly.

The country, which has the world’s most highly valued currency (its currency unit buys the most of any other currency unit), made the change in preparation to switch to the proposed GCC single currency, the Khaleeji, when it debuts in 2010 across Saudi Arabia, the UAE, Qatar, and Kuwait.

As long as the world’s energy trade balance favors the Gulf, our expectation is that the new currency will perform well against the dollar and euro, and it is likely that other members of the currency bloc will flirt with de-pegging prior to 2010.

The same analysis applies to China’s renminbi (which literally means “the people’s currency”). Prices may rise and growth may fall, but China will likely maintain its status as a worldwide manufacturing source and export-intensive economy; and turning a cold shoulder to U.S. dollar-denominated investments will put significant upward pressure on its currency.

One way to profit from this trend is by buying into the currencies themselves. EverBank (www.everbank.com) has a host of international currency deposit accounts, including a Chinese renminbi money market fund.

Alternatively, some investors are putting money in the Chinese renminbi exchange-traded note (NYSE:CNY). Beware before buying the renminbi ETN: You are accepting counterparty risk from Morgan Stanley so do not buy CNY if you think Morgan Stanley won’t be able to pay the note.

Personally, we are much more comfortable with Barclay’s Asian and Gulf Revaluation Fund (NYSE:PGD). This fund covers five currencies that are currently pegged to the U.S. dollar, and the fund stands to gain substantially if the pegs are revalued. The currencies include Hong Kong, Singapore, China, the UAE, and Saudi Arabia, and we are comfortable betting on the trend that at least the latter three will rise substantially against the dollar.

PGD charges a 0.89% management fee and was just recently introduced in mid-June. Its volatility will likely be mild, until, that is, one of the five countries revalues its currency.

P.S Fitzroy McLean is a co-editor of Without Borders, the spirited and highly profitable new monthly advisory service from Casey Research. A former military man turned spy, Fitz eventually came to his senses, trading in his cloak and dagger for a briefcase and a degree from Oxford, then set out to use his unique skills as a successful fund manager and full-time international entrepreneur.

Fitz and co-editor Simon Black, another former intelligence operative, are on a nearly non-stop quest around the world looking for the best places to easily diversify internationally (and, in the process, enjoy the best life has to offer.

There’s no other newsletter quite like it. But don’t take our word for it: a 3-month trial subscription with 100% money-back guarantee allows you to experience Without Borders for yourself at no risk. Learn more by clicking here now.

Source: “I’m from the Government and I’m Here to Help.”