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Letter to Shareholders – 2007 Annual ReportDear Fellow Shareholders, At first glance, 2007 mirrored much of what transpired in 2006. Once again, the year was generally a very positive one for the Asia Pacific region, marked by continued economic expansion and substantial returns for stocks. China and India again dominated the regional landscape. Both countries sustained their recent high rates of growth, and stock indices associated with the two countries were the best performing by a wide margin. As in 2006, Japan was the exception to the rule—it was the only major market in the region to experience tepid growth and declining equity markets. Even the major challenges confronting the region were familiar ones: political disruptions hampered stability and progress; Japan’s stagnation saw little respite; and China’s reforms, though impressive, were still underpinned by a fragile financial system and an autocratic government. While the broad contours of 2007 followed those of 2006, the year was in fact distinct from the past. Most notably, globally induced volatility was far more prevalent in Asia Pacific, precipitated by the collapse of “subprime” mortgage markets in the U.S. A decade after the region experienced its own financial crisis, Asian markets were impacted again, but this time by instability that originated from overseas. Though the U.S. was the epicenter of the mortgage-related woes, the ramifications were global. Markets in the region experienced sharp volatility throughout the year, as the appetite for risk waxed and then waned. However, Asia’s direct exposure to the subprime crisis has thus far been limited. Ironically, the financial crisis that swamped the region in 1997 left many banks chastened, and therefore less prone to pursue the sort of business models that gave rise to the current crisis. That said, some Asian banks have exposure related to subprime mortgages due to their purchase of dollar-denominated assets—losses in the region may exceed $50 billion. Yet during a period of sustained growth, liquidity and profitability, a loss of this magnitude will only dent profitability among Asian banks, not destroy it. For Asia, the subprime crisis has only posed a temporary threat to current earnings. There is no reason yet to believe that it will level balance sheets in the region, as it has done elsewhere in the world. Amid this volatile environment, the celebrated notion of “decoupling” was sorely tested. Many financial market observers have speculated that Asia’s fundamentals were evolving in a fashion that could move independently from the global marketplace. If true, this would fulfill an elusive promise for many investors—namely, that the region’s financial markets might hold up better even as others were deteriorating. We have previously stated that decoupling is, for the most part, a myth. Over the last several decades, Asian economies have grown much more closely integrated with other markets around the world, and this has been to their tremendous benefit. Enhanced trade flows, deregulation and more open markets have unlocked new and meaningful growth opportunities in Asia’s largest markets, such as China, India and Japan. Ironically, this has meant Asia has grown more coupled with the rest of the world, not less. Though external risks generally dominated Asia Pacific’s markets, a number of internal events also drove performance. China’s markets continued their remarkable ascent, catalyzed by the major reforms in the banking sector and stock market that began five years ago. China has been under intense scrutiny for its currency policies; yet 2007 saw China’s authorities introduce a number of important reforms to liberalize its currency. Perhaps most significant of these was a tentative plan known as the “through-train,” which was announced in August. Under this plan, Chinese individuals would be able to invest directly in Hong Kong (and in the process, sell their own currency, the renminbi). The “through-train” is currently in limbo. Nevertheless, the boldness of this plan was immediately evident upon its announcement, which came even as global markets were slumping sharply from mortgage-related losses. News of the plan sent stocks in Hong Kong to record levels during the ensuing weeks. Chinese stocks have backed off their late-October highs. Since then, a familiar risk has resurfaced: inflation. Toward the end of 2007, price increases escalated to levels not seen in a decade. In response, authorities have attempted to “cool off” the market by increasing interest rates and curtailing loan growth. This environment has created a headwind for Chinese equities; however, China is not alone in its battle against surging prices. Most countries in Asia Pacific are also experiencing higher levels of inflation. Inflation of this sort is a relatively predictable result of the region’s currency policies—and is not entirely detrimental, provided it does not reach excessive levels. It may even spur growth in certain domestic sectors across Asia, as they discover newfound pricing power. However, inflation also means that countries throughout the region may not have much room to cut interest rates, even as the outlook for the global economy is softening. Against this backdrop, the nine Matthews Asian Funds recorded varying performances for the year. During a year notable for its volatility, most of the Funds delivered relatively steady performance. This was particularly true during the final quarter of the year when almost every Fund outperformed its respective benchmark, holding their ground, or even gaining, despite slumping markets. More importantly, we remain very pleased with the Funds’ longer-term performance records. In fact, the Matthews Asian Growth and Income Fund was recognized by The Street.com as one of only two Funds in the country to beat the S&P 500 each of the last 10 years, and simultaneously generate positive returns during each of the last 10 years. While an achievement of this magnitude may not be repeated, this record illustrates the core performance goal of the Fund family. Rather than seek to outperform a narrow set of peers or benchmarks in a given year, the Funds aim to provide investors with a viable means to participate in some of the very best long-term growth opportunities that Asia Pacific offers. We would like to bring to your attention some recent changes to the management of the Funds. Effective January 1, 2008, Mark Headley, Chief Investment Officer of Matthews International Capital Management, LLC, the investment advisor to the Matthews Asian Funds, temporarily stepped down from most day-to-day business activities to focus on his health. Mark was recently diagnosed with a form of non-Hodgkin’s lymphoma known as Burkitt’s lymphoma. He is undergoing treatment and his doctors are optimistic that he will make a full recovery. During Mark’s absence Andrew Foster is serving as acting Chief Investment Officer. Mark has also stepped down from his role as lead portfolio manager of the Matthews Pacific Tiger and Matthews Korea Funds. Richard Gao and Sharat Shroff are now co-lead managers of the Matthews Pacific Tiger Fund. Richard has been a co-manager on the Fund for the last two years, and has almost a decade of experience managing Asian equities. Sharat has served as co-manager on the Matthews India Fund for nearly two years. With regard to the Matthews Korea Fund, Michael Oh, who shared lead portfolio management responsibility with Mark, will continue as lead manager. Michael joined Matthews in 2000, and became co-manager of the Matthews Korea Fund in 2006. Mark remains a co-manager of the Matthews Pacific Tiger, Matthews Korea, Matthews China and Matthews Asian Technology Funds. Mark’s dedication and contributions go beyond his duties and titles and we wish him a speedy recovery. Effective February 1, 2008, Andrew Foster is lead manager of the Matthews Asian Growth and Income Fund. Andrew served as co-manager of this Fund since January 2005. Paul Matthews will remain as co-manager, and will continue to research individual investment ideas and contribute to the portfolio’s overall strategy. In addition, Jesper Madsen, CFA, who has been co-manager of the Matthews Asia Pacific Equity Income Fund since its inception, has been named that Fund’s lead manager. Andrew Foster remains co-manager of the Fund. Thank you for your investment in the Matthews Asian Funds. We are honored to serve as your investment advisors. G. Paul Matthews Andrew Foster |
