Letter to Shareholders

July 2008

Dear Valued Shareholders,

The first quarter of 2008 will undoubtedly be remembered for its caustic markets; and yet the second quarter saw no respite. Equities around the world generally continued their descent, and shares in Asian markets suffered in tandem. Stocks retreated on concerns that the global economy might slow substantially, with U.S. financial institutions under severe pressure. These fears have weighed heavily on overseas markets, including Asia, though the U.S. credit market’s collapse has had only a limited impact on the fundamentals in the region so far. Thus, cumulative losses announced by Asian banks have been relatively small, less than 10% of the $400 billion estimated to have been lost globally. Meanwhile, the Asian region is still projected to grow at a healthy, albeit moderated rate: the International Monetary Fund forecasts that the economies of developing nations of Asia will grow at 8.4% this year, and Japan at 1.5%.

If there are greater concerns ahead for the region, they emanate from two other sources: accelerating inflation on consumer goods, and high energy prices, especially for oil. The latest readings of prices in the region generally suggest that inflation is running at the highest levels seen in the last one to two decades. As we have highlighted in recent commentaries posted on our website, this is not necessarily damaging in and of itself, provided that such inflation does not escalate to even higher levels. In our view, Asia’s greater challenge arises not from issues affecting the U.S., but rather the potential for policy errors by governments in reaction to burgeoning inflation. Many consumers in the region are expecting local governments to blunt or contain the impact of inflation on their living standards. Governments, in a bid to shore up voter support, have in turn sought to intervene in markets, typically via subsidies, price controls or trading restrictions. It is our experience that such intervention typically serves to exacerbate inflationary pressures, or makes them more structurally permanent. The region’s greatest risks are ultimately that policy overreaction may lead to greater market distortions and more permanent inflation, or may otherwise hinder the region’s growth prospects.

Oil prices have posed a second stumbling block to the region. Only a few decades ago, the region outside Japan and Australia was a relatively small consumer of oil and other natural resources. Several large markets, such as China and Indonesia, were once net exporters of oil. However, as the region’s economies have developed, local governments have done little to wean their industries off of hydrocarbon-based production and transportation systems. Worse, many governments have sought to subsidize energy prices domestically, so as to make fuels more affordable for end consumers (especially households). While this has meant that local economies have expanded smoothly in recent years, it has also meant growing distortions in the structure of the economies: many domestic consumers have not been forced to pay a market-based price for their energy consumption, and this has arguably led to excessive consumption and waste.

The bill for such subsidies, incurred by rising fiscal deficits in the region, has grown sharply in recent quarters as oil prices have surpassed $140 per barrel. Some currencies around the region have begun to swoon from such fiscal pressure. There is a small silver lining to this situation, though: during the last quarter, many Asian countries have been forced to reduce their subsidies, or depart from them entirely, as the sheer financial cost has proved too great. As market participants are forced to pay market prices for their consumption, it may induce greater conservation and efficiency in the future.

Asian markets have been decidedly weak in the first half, and we would make no predictions about their near-term course. Investors’ attention has rightly been focused on the current slump; however, to illustrate ways in which the region continues to evolve, we would like to highlight a few notable news events from the second quarter. During times such as these, it is important to cultivate an understanding of this evolution. It is this ongoing development that we, as long-term investors, remain excited about, even as the present condition of markets might be frustrating.

Perhaps the most notable of all these events was China’s growing political complexity and sophistication. During the past six months, China has been confronted with considerable challenges: severe blizzards threatened lives and crippled transport; the country’s relationship with Darfur was roundly criticized; suppression in Tibet invoked global scorn; and a tragic earthquake wrought destruction, killing more than 69,000. China’s leadership was tested on each of these occasions, and the results are safely interpreted as mixed. China’s slow movement on Darfur has come at terrible cost, and its suppression of Tibetan unrest has left even the country’s enthusiasts disappointed. Yet it would be a mistake not to acknowledge that there is also a different strain of thought emerging in the government, one characterized by a new sort of transparency, responsiveness and civic orientation.

While the affairs of Tibet remain murky, one could not help but notice that protests this spring garnered a greater level of international media coverage than in times past. Improved media access was even more apparent in May, following the earthquake that hit the Sichuan region. Journalists had nearly unrestrained access to disaster zones, as they reported on the devastation, the government’s response, and most importantly, on the political unrest that ensued. Press reports included accounts from bereaved parents who decried corruption, shoddy building codes and lax enforcement as reasons that many schools in the earthquake zone collapsed. While the media presented images of prostrate officials, kneeling before wrathful parents holding photos of their lost loved ones, many stories also praised the central government for its swift and thorough response to the crisis.

In our view, this sort of openness about a national catastrophe and its causes, as well as the responsiveness that ensued, is something new to China. The earthquake even initiated a small but notable political détente: for the first time since World War II, a Japanese naval ship was allowed into a Chinese port—this time with the intent of offering assistance. This small but symbolic gesture was accompanied by a landmark agreement between Japan and China to co-develop a set of underwater gas fields in long-disputed territory in the East China Sea.

A thawing of sorts also came to China’s dealings with Taiwan. More frequent dialogue has helped bridge some of the worst sources of tension between the two parties. The mood in Taiwan itself has shifted, as there appears to be increasing recognition that the country’s economic destiny (if not its political center) is forever intertwined with the mainland. Taiwan’s recent political election hints at as much, as the opposition party overturned the incumbent primarily on a platform that espoused better ties with China. Though few changes have taken place to cement such ties, direct airline flights between the two countries began on July 4th—an important symbol of the growing links between the two former foes. While there is much ground still to cover, this shift in the cross-strait relations, if it should deepen and become more permanent, would alleviate one of the greatest security threats hanging over the region.

In another part of the region, there was one more important change to Asia’s security sphere: North Korea took small but deliberate steps toward defusing its own status as a hostile threat. The country destroyed a cooling tower at one of its main nuclear facilities, and then shared details of its nuclear planning framework with international inspectors. For this, the U.S. has undertaken to remove North Korea from the U.S. watch list of terrorist-sponsoring nations. These events do not, by any means, constitute an end to the North Korea problem, but they do represent one of the biggest steps forward in relations with the country in the last decade.

Thus, even as financial markets have been shaken, the landscape in Asia continues to evolve in an encouraging fashion. Fundamentals in the region, including earnings growth, will undoubtedly suffer some in the current environment, though it has been encouraging to see that export and economic activity in the region remains robust, at least thus far. Valuations, of course, have declined, particularly as multiples have fallen faster than earnings estimates. This is a glass that is at once half full and half empty. Capital has been lost as markets have declined, but valuations are beginning to look more reasonable, and arguably are healthier, than they were not long ago. Most importantly, we see Asian corporates and consumers to be in fairly healthy shape, with high savings rates, income growth and low rates of leverage. It is this sort of condition that makes us confident in the long-term prospects for the region, even as present markets are challenging.

It is our great privilege to serve as your investment advisor in Asia. We appreciate your persistence amid difficult markets, and we pledge to continue to seek out Asia's investment potential in the years ahead.

Andrew T. Foster
Acting Chief Investment Officer
Matthews International Capital Management, LLC

G. Paul Matthews
Chairman
Matthews International Capital Management, LLC

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.