Commentary

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Quarter Ending June 30, 2008

For the six months ending June 30, 2008, the Matthews Pacific Tiger Fund declined –19.20%, while its primary benchmark, the MSCI All Country Asia ex-Japan Index, fell –21.10%. During the same period, the MSCI All Country Far East ex-Japan Index was down –18.21%.

Various stocks from across the region helped the Fund’s relative performance, but were unable to offset broader weakness in the markets. Asia ex-Japan equities ended the first half of the year with one of the worst performances in recent history. The economic environment across large parts of the region worsened in the second quarter, and any partial attempts at a recovery in the markets in April proved to be short-lived.

Inflationary levels have increased across the region to multi-year highs, led by rising food and fuel costs, which account for almost half of the consumer’s basket. Meanwhile, pricing pressures may become more systemic. With the exception of Taiwan and Korea, wages are also starting to rise in the region, threatening the longer term viability of many export-oriented businesses, particularly as currencies appreciate. To mitigate this affect, we have consciously avoided business models that rely solely on a weaker currency to arbitrage labor costs. Where the Fund does have exposure to export-oriented companies, the investment is predicated on the ability of management teams to generate sustainable sources of competitive advantage. A case in point is Sun Pharmaceuticals. The Indian company has managed to carve out a niche within the generic pharmaceuticals sector in domestic and overseas markets such as the U.S. Compared to some of its peers in India, Sun’s focus on specialty therapy areas including psychiatry, neurology and cardiology have allowed it to maintain healthy operating margins in excess of 35%. One reason behind its success has been its continued investment in research and development, regularly exceeding 10% of sales.

Beyond the near-term imperatives of inflation, the structural challenge for policy makers in the region is to continue to liberalize currency regimes, and rebalance growth by stimulating domestic consumption. Rising domestic consumption would alleviate the dependence on exports, and provide greater flexibility to currencies. Consumers in Asia have been resilient so far, although there are signs of moderating demand. Higher interest rates are crimping the ability to spend, particularly on big-ticket items. But Asian households are still sitting on trillions of dollars of savings that can help buffer rising cost pressures, although that is unlikely to happen immediately.

In the long term, the next big story to unfold will be China’s gradual shift from being a producer to becoming a consumer. Our strategy has been to focus on the creation of newer markets that are aided by an environment of liberalization and deregulation. One good example of such an approach is Dongfeng Motors, one of the largest auto manufacturing companies in China. The availability of auto financing has gained momentum in China only in the last few years. That, combined with rising household wealth, has translated into growing demand for automobiles. In the near term, rising interest rates, surging commodity costs, and costlier gasoline have created an overhang for Dongfeng. We believe the company has been proactive in rolling out new models, and has demonstrated the ability to grow consistently at 20% over the past several years. It is well-placed to benefit from rising consumption in China.

Even though it has been painful, the Fund remains consistent with its discipline of staying fully invested through these volatile markets. Our approach to risk mitigation stems from focused security selection instead of trying to build cash levels in anticipation of the next trough in the market. Asian equities have been correcting since early November, with India peaking in the first week of January. What began as a healthy adjustment to investor expectations has appeared more indiscriminate in recent weeks. We continue to believe that Asian lifestyles have improved significantly in the last decade, and will continue to improve in the coming years. Some of the recent additions to the portfolio, particularly in the media and tourism sectors, are likely to benefit from this trend. We have also raised stakes in some of our holdings that offer wealth management services in the region.

Asia is currently in an unusual position. On the one hand, the world sees it as one of the few engines of growth globally. In fact, on the basis of purchasing power parity, Asia accounts for more than 40% of global GDP growth. Yet, there are considerable uncertainties that may cause some pain for companies and consumers. Political shifts in countries such as Thailand and Malaysia add another layer of uncertainty. However, we remain enthused by the flexibility of Asian economies to evolve. During the Asian crisis, many pundits predicted a lost decade for Asia, but the region was able to turnaround in less than 18 months and resume growth. Even as many parts of the Western world are experiencing some devastation to wealth, there is a secular trend toward wealth creation in Asia, and we believe our portfolios are positioned to participate in that.

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 Pharmaceuticals accounted for 2.7% of the Matthews Pacific Tiger Fund and Dongfeng Motors accounted for 1.1% of the Fund.