Commentary

Quarter Ending March 31, 2008

For the first three months of 2008, the Matthews India Fund declined –22.95%, while the benchmark Bombay Stock Exchange 100 Index fell –27.41% during the same period.

India’s markets suffered sharp losses during the first quarter, despite commentators’ assertions that somehow the country’s domestically driven economy would “decouple” from troubles elsewhere. At Matthews, we have always thought differently. True, the facts support the claim that India’s economy is domestic in nature: The export sector is woefully underdeveloped. However, this does not mean that India might somehow hive itself off from the rest of the world. India is, in fact, highly dependent on capital flows from abroad to support its growth.

Large fiscal deficits at both the national and state levels mean that the government crowds out private markets in classic fashion. India enjoys high savings rates; yet a boom in household debt means that much of the country’s marginal savings—those above and beyond the government’s expenditure requirements—have gone to fuel household consumption in the form of mortgages, auto finance and consumer loans. This has meant precious little capital has been left for investment by private companies. Indeed, India runs a capital account deficit, meaning that it must import capital from abroad to support its consumption. As the global tolerance for risk has retrenched, flows of capital bound for India have slowed—and thus it can be no great surprise that local markets have slumped in response.

Capital markets in India have had a rough year, but there are signs of continued improvement as well. On the negative side, several large IPOs have failed to occur, and other capital raisings have been deferred. Such hiccups have thrown certain segments of the market into convulsions. Conversely, however, the market has shown increasing capacity to differentiate higher quality companies from lower quality ones. This is an essential ingredient to the economy’s future health, as it means that stronger companies will enjoy better access to capital, enabling faster growth; and less capital will be wasted on sub-par companies.

Most indications suggest that profit growth will moderate slightly, but from levels that would be considered high from a historical perspective. Margin pressures have begun to weigh on most industries. Inflation is driving up material and labor costs faster than many companies can re-price their own goods and services. Also, companies are beginning to falter due to the “high base effect,” meaning that such companies have grown so rapidly they are finding it hard to grow relative to their newly enlarged revenue bases.

Looking forward, inflationary pressures remain one of the greatest difficulties for the economy. We have expressed our concerns about inflation for almost two years now. Contrary to our expectations, inflation moderated during most of 2007, but has recently returned with a vengeance. Hopefully, the burgeoning problem can be contained. India’s central bank has historically exhibited a high degree of independence, and has fought inflation doggedly, especially when ignited by excess credit growth on the part of local banks. However, the country has entered an election year, and thus the risk of populist policies that might result in a misstep is higher.

Despite the challenging conditions in current markets, we remain enthusiastic investors in India. The economy’s recent growth is neither transient nor fictional: It has been rooted in improving fundamentals, underpinned by regulatory reform, market liberalization and private sector expansion. However, we would caution investors not to invest on a false premise, namely the belief that India has stood apart from the rest of the world. India has grown especially because it has enmeshed with the rest of the world—it has been a key beneficiary of “globalization.” Thus, despite the country’s investment merits, it is unlikely to provide a safe haven amid the volatility of the global marketplace.

The views and opinions in this commentary were current as of March 31, 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.