Commentary

Quarter Ending June 30, 2008

During the first half of 2008, the Matthews India Fund declined –37.36%, while its benchmark, the Bombay Stock Exchange 100 Index, fell –42.03%.

Indian shares suffered a sharp collapse during the second quarter, buffeted by two intertwined storms: inflation and record oil prices. We have been concerned about the pace of inflation in the country for some time now, dating back to the Fund’s launch in October of 2005. We had seemingly been wrong to harbor such concerns: until the beginning of this year, inflation had been remarkably quiescent. It is not certain whether this was testament to the growing efficiencies of the domestic economy, or more worrisome, whether this was the result of faulty measurement (India does not measure consumer price inflation at the national level). Whatever the case, inflationary pressures returned with a vengeance this year, with wholesale prices currently rising in excess of 11% per annum. This has created a headwind for stocks for dual reasons: first, corporate profits must contend with rising prices on most inputs, possibly squeezing margins; second, and more importantly, the national central bank, the Reserve Bank of India (RBI), has been prompted to raise rates. India owes its growth in recent years to many underlying causes, not least a relatively benign interest rate environment. However, the RBI is one of the most independent and capable central banks in all of Asia; and with pricing pressures mounting again, we would expect the bank to fight inflation doggedly, raising and holding firm interest rates, as it has already done.

Indian markets have also suffered from higher oil prices. For some time now, India’s government has adopted a policy that subsidizes energy prices for some domestic constituencies—especially for cooking, heating and transportation. However, India’s own hydrocarbon resources are very limited; this has meant that as global oil prices have risen, the fiscal deficit arising from the subsidy policy has overshadowed the markets. India has famously suffered from one of the largest fiscal deficits in the world (measured relative to the size of the local economy). Unfortunately, even as tax revenues have grown at record rates during the past few years, government spending has not slowed, meaning that the deficit is quite large even before taking into account the impact of the energy subsidy. Yet now as oil prices have accelerated, the energy subsidy has begun to dwarf nearly all other components of the deficit. Consequently, global investors have lost a measure of faith in the local currency, as well as the country’s growth prospects. This in turn has pushed India’s currency, the rupee, and stock prices substantially lower.

Amid a very difficult six months, there was little shelter in the marketplace. From the portfolio’s perspective, the greatest positive returns arose from its holdings in pharmaceuticals. Indian pharmaceutical companies continue to make inroads to the global marketplace, particularly as the cost of health care around the world dictates that many seek cheaper drug alternatives—which India is well-suited to provide. Two of the Fund’s best-performing positions during the first half, Sun Pharmaceuticals and Glenmark Pharmaceuticals, exemplify this idea. Both enjoyed profits derived from the domestic marketplace, but their performance during the quarter was even more linked to the perception that each has begun to successfully tap the global market for generic drugs

At present, nearly all of the Fund’s gains from last year have been surrendered amid the market’s broader decline. However, the Fund’s emphasis continues to be to generate long-term returns, rather than to beat a benchmark in a given quarter. The Fund has offered a modicum of relative outperformance, falling less than the market as a whole. Notably, this has been achieved without retreating to cash, but rather via security selection and diversification. Nevertheless, this sort of relative outperformance is of little consolation to those shareholders who have invested with the Fund more recently.

It is in this regard we remain focused on improving the Fund’s long-term record, despite its losses in recent months. This long-term perspective is important because, as you will note, from its inception to the present, the Fund has offered substantial absolute gains, and has outpaced the S&P 500. More importantly, even as India may stumble from time to time, we remain enthusiastic long-term investors in the country. We believe that the economic evolution and modernization that has taken hold there is neither transitory nor reversible. Volatility, often in the extreme, is to be expected from such a transition; yet we also believe that over the long term, the inherent risks will be compensated with commensurate reward.

The views and opinions in this commentary were current as of June 30, 2008. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Funds' future investment intent.

Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.

As of 6/30/08, Sun Pharmaceutical Industries, Ltd. accounted for 4.8% of the Matthews India Fund and Glenmark Pharmaceuticals, Ltd. accounted for 4.5% of the Fund.