Commentary

Quarter Ending September 30, 2008

The Matthews China Fund ended the third quarter of 2008 down –19.30%, while its benchmark, the MSCI China Index fell –25.22%, as Chinese equities declined sharply. Most of the decline came in September as the global credit crisis left a devastating impact on stock markets around the world, including China and Hong Kong.

The third quarter of 2008 marked a turning point for China’s monetary policy. After more than five years of tightening, China shifted the focus of its monetary policy from fighting inflation and overheating to stimulating growth. For the first time in six years the central bank cut interest rates and eased bank lending restrictions. The move came in response to signs of a slowdown in the domestic Chinese economy, and more importantly, was part of the government’s efforts to protect its economy from a global downturn.

China is not immune to the global credit crunch. Although its export sector has been holding up relatively well so far, we believe that going forward it will see a sharp decline due to weaker global demand. However, China’s strict capital control, its low foreign debt and immense reserves of foreign currencies have thus far insulated its financial systems from the troubles shaking Wall Street. China’s banking sector has very limited exposure to subprime-related assets, and is generally healthy. We believe China is in an overall good position to withstand much of the global financial turmoil. That said, we expect China will continue to see a slowdown of its economy from its historical high growth in the first half of last year and that the central bank will be more aggressive in cutting interest rates, especially given the current severe global credit crisis.

During the quarter, the Fund’s defensive positions in the utilities and consumer staples sectors were the top contributors to the portfolio. Overall, the Fund’s small- and mid-cap holdings performed relatively better than large-cap ones. The market sell-off was widespread and we took advantage of the sharp correction in tourism and advertising-related stocks to increase our exposure in those areas. We believe that the slowdown in the tourism industry was due to some extraordinary factors such as the year’s crippling snowstorms, Western China’s tragic earthquake and the temporary tightening of visa approvals during the Beijing Olympic Game. As these issues resolve themselves, we are seeing solid tourism companies benefiting from the industry recovery.

One widely reported crisis for China in September was a milk contamination scandal that erupted after four infants died and more than 50,000 children were sickened from dairy products contaminated with an industrial chemical known as melamine. More than 20 dairy manufacturers were found to be involved. Though Chinese authorities have ordered that tainted baby formula products be recalled and destroyed, the incidents were damaging for all of China’s dairy companies, including some better-known brands, and harmed consumer confidence in food safety. What has been encouraging, however, is that the public outcry that followed has revealed a level of transparency that is relatively new to China, and should prompt companies to take better precautions and quality controls for protection of their brand equity.

The Fund continues to focus on the domestic consumption growth areas with less exposure to the external sector. We have been encouraged by the quarter’s strong retail sales growth rate of more than 20%, a sign that domestic consumption is still keeping momentum with wage growth. How much of this will be affected by the mild slowdown of the domestic economy and the global financial crisis remains to be seen. However, we are convinced that China will be increasingly reliant on domestic growth, and our portfolio is built to benefit.

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.