Letter to Shareholders

October 2008

Dear Shareholders,

At a moment when markets worldwide are in a state of disarray and panic, we at Matthews would like to offer our thanks for your continued confidence and trust. We appreciate your focus on the long term and your ongoing support.

We are keenly aware of the cost of staying invested throughout the extreme swings of all market cycles, especially the current one. Most of our Funds have outperformed their respective benchmarks year-to-date, though this may be of little consequence when absolute losses have been so steep. However, those of you who have invested with us over longer horizons may recognize that we have seen similar conditions before, particularly during the financial crisis that swept through the Asian region a little over a decade ago. Our experience from that time leads us to believe the market’s current swing offers opportunities for those who pursue a disciplined, long-term investment process. Matthews has weathered such periods of distress before; now we will use the same approach, and aim to take advantage of the current conditions via the relatively attractive valuations they afford.

There is a cliché among investors that “cash is king.” This is because cash provides precious liquidity. It can buy capital resources, business options and even time. It serves as ballast in the storm. Nevertheless, the cliché is mistaken: confidence is the real king, and cash only its consort.

The importance of confidence was never more apparent than during the third quarter, when many long-standing pillars of the U.S. financial system collapsed for lack of it. Fannie Mae, Freddie Mac, Lehman Brothers, American International Group: all had operated thinly capitalized businesses that could be sustained only as long as confidence was intact. Certainly, the poor liquidity and the narrow solvency of these institutions hastened their demise. These institutions managed to sustain their businesses for some time, and enjoyed market capitalizations worth billions until the very end. It was only when confidence waned that each of these companies collapsed overnight. Markets remain volatile as U.S. authorities continue to grapple with a solution that could restore the trust that has been so badly broken.

Asia—From a Fundamental Perspective

As for the Asia Pacific region, it is grappling with the spillover shocks that have emanated from the U.S.-centric panic. From a fundamental perspective, the region and its financial architecture are quite healthy. The legacy of the financial crisis of 1997-1998 is still tangible in the region, especially in that most companies (and especially banks) have managed their balance sheets in such a way as to reduce leverage and preserve liquidity. Thus far, banks across the entire region have disclosed surprisingly low exposure to collateralized debt obligations (CDOs) and the like—about $25 billion in total (whereas the Swiss investment bank UBS disclosed $45 billion in losses alone)¹.

Fundamental analysis suggests that the Asian region is unlikely to suffer the same sort of balance sheet implosions that have undermined so many segments of the U.S. marketplace. Savings are high, and earnings in many segments of the market continue to grow, albeit at a more moderate pace than the past few years. Nonetheless, at this moment, fear has come to dominate markets; acting as a fundamental force in its own right. Companies with a pressing need for capital, but that lack access to it, may struggle in the coming months as banks around the world sort out the current confusion. Asian stock markets have reacted swiftly and without discrimination, reducing the valuations on large swathes of companies irrespective of their fundamental health. We intend to concentrate on those investments that we believe have sufficient resources to weather the current downturn, and whose share prices have been unduly affected along the way.

Asia’s economic growth will undoubtedly be hampered by a sharp decline in global growth, should one occur as most analysts now forecast. The region’s trade linkages with the rest of the world are far more diversified than they once were, but Asia is obviously not immune to a global slowdown. However, the macro environment is not wholly negative: just a few months ago, inflationary pressures were plaguing most countries in the region; now those same pressures have begun to subside. Most importantly, oil prices have come off sharply, offering a welcome reprieve to the region’s larger economies such as China, India and Korea, all of which are net-importers of petroleum. Against this backdrop of greater price stability, and replete with high levels of domestic saving, Asian economies generally enjoy room to cut interest rates, ease domestic liquidity conditions, or in some cases, even engage in fiscal stimulus. Indeed, central banks in Australia, China, Hong Kong, India, Korea, Taiwan and New Zealand have already acted to increase domestic liquidity supplies by cutting interest rates or bank reserves, and additional measures may well follow.

Ultimately, we believe both the region’s fundamentals and the case for long-term investment remain intact, despite the current crisis. Perhaps the greatest threat the region faces is of a more subtle nature, one highlighted in some of our earlier letters: the growing risk of policy error on the part of local governments. Earlier in the year, some Asian leaders restricted trade activity or imposed selective price controls in reaction to higher inflation. While understandable, this response highlights the uneasy embrace that Asia has with free and open markets. The current financial crisis may only exacerbate the problem: for decades the U.S. capital markets have been the envy of nearly every finance minister in Asia, and many sought to emulate their success at home. Yet those markets have now been discredited, not least because of uneven regulation. It may provoke some in Asia to pause on the path toward more open markets. If this shift in attitude is combined with a major bout of global protectionism, it may set back the evolution of Asian markets for some time to come.

Positive Changes

Yet still, there are many good reasons to hold out hope: China, the country arguably at the epicenter of such tensions, is bearing up best under the pressure. Regulators in the country have made what appears to be an unflagging commitment to further domestic financial market reforms, even amid a broader crisis. Meanwhile, the leadership continues to debate land reforms that have the potential to unlock much of the economic potential of the interior states, where the majority of the populace still resides in near abject poverty. China’s 800 million farmers have been constrained by relatively short usage rights of 30 years—extending these rights to 70 years and putting in place a formal legal infrastructure for transference and renting out land use rights would improve rural communities’ ability to derive an income from their land holdings. These possible measures are but part of a broader package that aims to double rural incomes in the next decade.

On investment performance: while we are disheartened by the declines in Asian stock markets, we are pleased that the relative performance of the Funds continues to hold steady. Notably, the Funds for the most part sidestepped the recent collapse in commodity and resource stocks. Philosophically, the Funds aim to stay invested across market cycles, and therefore prefer to target companies whose growth is more sustainable than is often the case in pro-cyclical industries. Also, we note that the performance of the Funds has been somewhat dispersed year-to-date, with the two income-oriented Funds offering greater insulation from the market’s recent volatility. This outcome is in keeping with our expectation, in that we have long felt that distinct strategies are capable of yielding differentiated results, even in “emerging markets.” Our goal has been to help investors capitalize on the growing breadth and depth of the Asia Pacific capital markets by offering a diverse range of strategies across the risk/reward spectrum.

Asia’s market capacities have expanded over the last decade, as evidenced by higher trading volumes, improved liquidity conditions and higher levels of issuance in primary markets. This added depth and breadth has meant, in our view, that private capital markets have achieved a newfound prominence in the region that is not likely to be derailed even by the current financial panic. In light of the new depth and capacity, Matthews undertook two initiatives during the third quarter: first, two of our Funds, the Matthews Asian Growth and Income Fund and the Matthews Pacific Tiger Fund, were re-opened to new investors. Second, Matthews launched a new fund that is dedicated to investment in Asia’s smaller companies. We feel that the growing breadth of private capital markets in the region may give investors access to a wider range of better quality companies. Meanwhile, smaller companies are likely to benefit from the emergence of private markets, as it means they are less dependent on government-linked banking systems for funding. For both of these reasons we are pleased to introduce the Matthews Asia Small Companies Fund. Read Commentary from the Fund's managers.

Again, we appreciate your support and your focus on the long term. As always, we are honored to serve as your investment specialist in the Asia Pacific region, particularly at this challenging moment in global markets.

Sincerely,

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

Robert J. Horrocks, PhD
Director of Research
Matthews International Capital Management, LLC

G. Paul Matthews
Chairman
Matthews International Capital Management, LLC

¹ Bloomberg: WDCI function, 10/13/08

As of September 30, 2008, the Matthews Asia Funds held no positions in any of the companies mentioned.

The views and opinions in this commentary were current as of September 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.