Commentary

Quarter Ending September 30, 2008

During the third quarter of 2008, the Matthews India Fund declined –12.61%, while the benchmark Bombay Stock Exchange 100 Index fell –12.58%.

The Fund’s performance during the third quarter was generally in line with that of the broader market: that is to say, there was little shelter amid the broad decline in Indian shares, and neither the Fund nor the broader indices escaped the global downtrend. We feel the decline in performance that the Fund has suffered very keenly, and appreciate your ongoing support and long-term focus.

In local currency terms, the Indian market held up somewhat better than its counterparts in the rest of the region; however, the sharp depreciation of the local currency, the rupee, meant that returns for dollar-based investors were weaker. As we have highlighted before, India faces a daunting set of twin deficits: it runs a current account deficit due to trade imbalances, and the largesse of the local government has meant that the country has one of the larger fiscal deficits in the world (when measured versus the size of the domestic economy). The scale of these two deficits ostensibly weighed heavily on the currency during a time of broader market weakness, causing the rupee to give back much of its gains over the past few years.

Unfortunately, local politics served to augment some of the current volatility in stocks. The country is anticipating elections in 2009, and as control over the government rests on a fractious coalition, current policy has tended to swing toward populist agendas. For instance, several measures have recently been introduced to subsidize farm activities or extend debt forgiveness to segments of the agricultural sector; all of this only puts greater pressure on the fiscal deficit. However, there are some signs that the current leadership may enact new reforms, including divestment of public sector entities. This would be a great boon to the country, if for no other reason than the proceeds from divestment could go to offsetting some of the national debts.

Other than currency weakness, markets suffered in large part because domestic liquidity conditions remain tight, particularly at the short end of the curve. Over the last several quarters, the Reserve Bank of India (RBI) sought to stem inflationary pressures by using several measures to tighten monetary conditions. As late as July, the RBI was still raising rates, moving the local repurchase rate from 8.5% to 9.0%. However, as the U.S. credit crisis has unfolded, it has put enormous strain on liquidity conditions in security markets around the world, and India is no exception. In this light, domestic monetary conditions in the country are now arguably too tight, and this in turn has hurt stock prices. The RBI has begun to ease conditions, especially now that even some of the largest domestic banks are struggling with liquidity. If the government acts decisively, it has ample room to maneuver, as local Indian banks have steep regulatory capital requirements which could presumably be relaxed somewhat in order to enhance the availability of liquidity.

As for the Fund, we remain focused on the fundamentals of individual companies. It is tempting during moments such as these to shift attention to the extreme volatility that is prevalent around the globe. While this perspective is not invalid—and investors should ensure that their aggregate portfolios are attuned to such risks—it is nonetheless the case that markets can lose sight of fundamentals due to overwhelming fear. When we look at India, we see much to like: overly restrictive regulatory controls have been further dismantled, prompting an acceleration of foreign direct investment into the country. Earnings growth appears to be moderating, but from very high levels; thus profit growth is moving down from a hectic pace of over 20% to something more sustainable in the high single digits. Most encouragingly, Indian equity markets are presenting valuations in some sectors and on some stocks that we have not seen for a while, and thus the long-term potential looks more favorable, especially in sectors such as financials and real estate.

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.