Commentary

Quarter Ending June 30, 2008

The Matthews China Fund ended the first six months of 2008 down –23.99%, while its benchmark, the MSCI China Index, fell –26.33%.

After a sharp decline in the first quarter, Chinese equities staged a strong rally in April, supported by early optimism that the global economy was hitting bottom, and by better-than-expected 2007 corporate earnings results. However, all April gains were wiped out in the following two months as the market refocused on record oil prices and China’s continued battle with inflation.

The first half of 2008 posed several challenges for China’s economy, stock markets and its people. As China prepared to celebrate its Lunar New Year holiday in late January, the country suffered its biggest snow storm in 50 years, affecting tens of millions of travelers. The country’s next crisis came when a devastating 7.9 magnitude earthquake struck western China in May, resulting in a tragic human toll of more than 55,000 dead. Although the overall economic impact from the two natural disasters was limited, some short-term disruptions in economic activity and consumer behavior were seen. With respect to inflation, the central bank seems to have made some progress as food-driven inflation trended down from its peak level by the second quarter. However, China’s latest move to raise both fuel and electricity prices added some renewed pressure on overall inflation. In the stock markets, the domestic A share market’s sharp decline of about 55% from its peak levels in 2007 (the Fund does not invest in A shares) had a negative spillover effect on Chinese equities listed in Hong Kong.

The Fund seeks to invest where we identify new markets emerging. With the ongoing rise of China’s middle class many of these markets tend to be in the consumer and financial sectors. What we have seen and heard during recent visits to China have reaffirmed our view that rapid income growth has been generating increasing consumer demands, and the momentum does not appear to be slowing. We also see banks and insurance companies continuing to improve efficiencies and expand into new business areas. We, therefore, continue to have overweight positions in these areas. However, the Fund saw heavy selling pressure on most sectors in which it is invested. The consumer discretionary, industrials and financial sectors were again the worst-performing sectors in the second quarter after suffering the most sell-offs in the first quarter. The financial sectors woes came mainly from the decline of the A share market. Consumer companies were hurt by the correction in the high-flying and high-valuation consumer discretionary sector.

The information technology sector has been a bright spot in the portfolio. Internet-related companies in the IT sector stood out as relatively strong performers during the period. Our holdings in this area include China’s top online gaming companies, the country’s most popular web portal, and the online company that built China’s biggest online community. Internet-related firms still make up a high-growth segment in China, and these companies are all market leaders in their respective business segments.

During the first half of 2008, the Fund was fully invested and we made very few changes to the portfolio. The Fund continued to be oriented for domestic growth with diversified allocations to different sectors. During this volatile market environment the Fund showed its relative defensiveness as a result of our diversified approach, and stuck with quality companies in which we have long-term convictions. We did, however, sell Petro China, and in turn increased our position in CNOOC. Although Petro China is the country’s largest upstream oil explorer, it has not benefited from recent oil price spikes. Its upstream profits have been offset by its downstream oil refining losses as the government has placed strict controls on downstream products. The Fund has also started a position in the online travel agency Ctrip International. Ctrip, which offers hotel and airline bookings, has secured its dominant position in this new and rapidly growing industry. In building up the portfolio’s consumer holdings, we have been looking not only at traditional consumer companies but also at companies that tap into new areas of consumption growth. Ctrip is one such company to create a niche new market, and it has been experiencing strong growth.

February 19, 2008 marked a decade since the Fund’s inception, and through the end of June it posted 10-year average annual total return of 18.15%. Since the Fund’s launch, China has experienced the Asian financial crisis, the dotcom crash, and the outbreak of a viral illness known as the severe acute respiratory syndrome (SARS), which all had devastating short-term effects on the Chinese economy. China is currently facing some challenging issues—among them are growing inflationary pressures and the challenge of balancing growth while controlling inflation—and we believe the stock market will likely be volatile in the near term. However, we are convinced that the long-term economic fundamentals remain solid and the domestic consumption growth story remains unchanged. As always, we try not to overreact to short-term market volatilities, and instead focus on holding quality stocks that will ride through tough times and stand out as winners in the end.

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, CNOOC, Ltd. accounted for 3.4% of the Matthews China Fund and Ctrip.com International, Ltd. accounted for 0.2% of the Fund. The Matthews China Fund holds no positions in PetroChina Co. Ltd.