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MATTHEWS ASIA ANALYSIS OF MARKET EVENTS IN CHINA

©2016 Matthews International Capital Management, LLC       2

Q: What about China’s move to remove the circuit

breakers? Is this another signal of the Chinese

government’s failure to attempt to save the market?

Andy Rothman: The decision to remove the circuit breaker

was great. It showed a high degree of pragmatism and realism

on the part of the Chinese government, and they addressed their

mistake with a surprising amount of candor.

Q: Is the market overreacting to currency movements?

Teresa Kong: In the very short term, the currency movement

has been quite large from a statistical perspective. One of the

key indicators we look at is the difference between the offshore

(CNH) and onshore (CNY) renminbi exchange rates. There is a

lot of offshore selling of renminbi and right now we’re seeing

the widest gap since 2011, when there was concern about the

possible breakup of the euro. So we’re definitely at a peak point

of fear based on the indicators that we look at.

If you have a longer than two-year view, I think this could be a

great entry point. If you have a one- or two-month view, hold

on tight. It is going to be very volatile, I think, over the next

few months.

Q: If China were to devalue the RMB by 10%, how would

that impact other Asian economies, or would it at all?

Teresa Kong: Because we’re no longer in a pegged currency

world, but one in which currencies are moving relative to other

currencies, there is the potential for very large gaps, either up or

down. If the renminbi were devalued by 10%, a lot of the other

basket currencies would most likely also be devalued similarly.

That would indicate to me that commodity prices have

continued to fall and there is increased uncertainty driven by

geopolitical events that we have not priced in. In that type of

environment, most likely a lot of other high-beta currencies

would be hurt.

Q: Renminbi depreciation would favor the old Chinese

economy. If they're looking to change the economy towards

consumption and services, why would the government

devalue the currency?

Andy Rothman: The government is not devaluing the currency

for any reason other than in response to a strong dollar. This is

not what they wish to do. If the dollar is flat this year, the

renminbi will be likely flat against the dollar as well. At the

same time, I do not think that devaluation is going to create a

problem for rebalancing the economy. The peak in investment

in construction of infrastructure and new homes has already

passed. The exposure of the average Chinese consumer to

imported goods is actually quite low. I expect this will be the

fourth consecutive year in which services and consumption will

be bigger than manufacturing and construction, and I would

guess that we’re likely to see consumption contribute roughly

60% of China’s GDP growth this year.

Teresa Kong: China is now the biggest importer and the

biggest exporter in the world. So we need to recalibrate our

understanding of the economy, instead of just thinking about it

relative to the dollar. There are two real secular trends in China.

One is that the growth rate is slowing, but the second is that the

value added in Chinese companies is increasing. They are back-

solving a lot of technologies they have gotten from places like

Korea and Japan, and they are now producing components and

parts they did not produce before, all the way up and down the

value chain, from low value-added goods like steel to much

higher value-added goods like precision parts and high-tech

products.

Q: Recent media articles have been casting doubt on the

health of the Chinese services sector. Are services slowing?

Andy Rothman: Pretty much every part of the Chinese

economy is decelerating. Even the biggest and healthiest and

fastest growing parts of the economy are going to be growing a

little bit more slowly each year. The fact the services sector is a

little bit slower this year should not surprise anybody, but the

MATTHEWS ASIA ANALYSIS OF MARKET EVENTS IN CHINA

©2016 Matthews International Capital Management, LLC       3

growth rates are still fantastic, off of a base that is getting much

bigger. One of the best bits of evidence of the health of the

consumer and services part of the economy came in the second

half of last year. The A-share market declined sharply in June,

over 30%. The second half of the year saw the best

performance in the consumer part of the economy. This tells us,

again, that the indexes don’t reflect the economy. Income is

still growing, household debt is very low and consumer

sentiment is quite healthy.

Q: There has been some discussion about capital outflow

from China and the decrease in foreign currency reserves.

If foreign currency reserves seem to be going down, does

capital outflow automatically follow?

Andrew Mattock: The numbers that we get are based on

official currency reserves. That doesn’t include the amount of

U.S. dollars deposited in the domestic banks within China.

I think if you add the commercial banks, the extent of the drop

in overall U.S. dollar reserves is nowhere near as severe as the

official numbers might indicate. There is definitely some

capital outflow. The government, as part of its reform process,

is allowing some degree of diversification of people’s assets to

outside of China, with restrictions as to the amounts people can

take out.

Andy Rothman: I would add that the evidence seems to

indicate that some of the reduction in official reserves has been

just a transfer of dollar assets from the accounts of the Central

Bank to the accounts of the state-owned banks.

David Dali: Just to clarify, if you see a drop in foreign

currency reserves reported in the news, that doesn’t mean that

those dollars are actually leaving China. It could be new dollars

that have been transferred to bank deposits.

Q: The Chinese government, broadly speaking, has been

fairly successful so far in managing the economy and GDP

growth. It has put a lid on company defaults and it has

maintained a fairly stable currency. But what are the risks

that the government is losing control of the situation at this

point?

Andy Rothman: The results of China’s economic reform

process over the last couple of decades have been quite good.

We’ve seen a tremendous increase in the role of the market, the

market sets most prices, more people work for private

companies, and people have gotten much wealthier.

Nonetheless, there have been mistakes along the way. It seems

every quarter for at least 10 years, we’ve seen headlines about

how China’s government has made yet another mistake and the

end is near. This is magnified by the much greater impact that

China has on the world today and the attention everyone is

paying to China. There’s always the risk that policy mistakes

won’t get fixed, but based on the track record that we have seen

over the last couple of decades, I think the odds of that are

pretty low.

Q: Should we be worried about cracks in the Chinese

financial system due to the rapid rise of debt within the

economy, and does this mean that we could potentially have

a future credit problem?

Teresa Kong: The total credit growth in China since 2008 has

been one of the fastest in history, so there are bound to have

been a lot of bad loans made. China has a few positives in its

favor, however. The first is that the loans have largely been

made by onshore banks and investors, meaning they have not

had to go out and borrow in someone else’s currency and be

subject to exchange rate volatility.

Certain sectors, notably property, have borrowed U.S. dollars,

but in the last six months most of these property developers

have refinanced locally at lower rates than the offshore market.

There is not an immediate liquidity problem, because the local

onshore bond market is vibrant, and a lot of companies have

accessed that market over the last nine months.

MATTHEWS ASIA ANALYSIS OF MARKET EVENTS IN CHINA

©2016 Matthews International Capital Management, LLC       4

The big crack in the system from my perspective is the lack of

credit analysis. I think that there is still a notion among credit

investors in China that, if you're a state-owned enterprise or a

large household name, there is no way your company can

default. The state won’t allow it. I think that is a

misunderstanding. Defaults are a necessary evil, and I think

over time the state will differentiate between sectors that are

more strategic and ones that are not, and companies that are in

sectors that have too much inventory will need to be

restructured.

Another big crack is that we really don’t have any precedent for

understanding how the onshore bond market will deal with

defaults, and whether there are any mechanisms for bankruptcy

or restructuring. We see that reflected, currently, in bond prices.

There is not much differentiation between a very good

company and a poor company in terms of credit spread. The

government is well aware of this issue and is working on fixing

it gradually over a period of several years.

Andy Rothman: I expect that the government is going to start

letting more companies fail, especially private companies and

even some state-owned companies, particularly in the

construction-related sectors where there is excess capacity in

places like steel and cement and aluminum. This is what they

should be doing, and we should be happy about it, but it is

going to generate scary headlines. “A company just failed in

China!” Well, companies fail in the U.S. all the time and we

understand that that is part of the process. But let’s be aware, it

is going to create more anxiety and volatility.

Q: What should US investors be thinking about in this

market environment?

Andrew Mattock: From an equity market point of view, I

think the biggest factor over the last couple of years has been

earnings per share growth. Since 2010, earnings per share

growth in China has slowed down, based on the MSCI China.

With that slowdown, has come a de-rating of the price people

are willing to pay from a P/E perspective. Over the next one to

two years, I am looking for that earnings per share growth to

come back for people to have confidence at a corporate level in

aggregate across China. There is growth in earnings, and as the

indexes more accurately reflect the underlying service sector

growth and the emergence of new companies, I think that will

give people a degree of confidence in the equity market that

we’re back in a growth market.

Teresa Kong: When we look at historical data, if you had

bought US. dollar-denominated debt of Asian companies at the

current level, you wouldn’t have lost money if you have a

holding period of greater than two years. If you have a greater

holding period, that just means your returns would have been

better. If you are able to get exposure to a long-term U.S. dollar

credit strategy that doesn’t necessarily have as much of the

currency volatility, which we think will continue, we think this

is actually an opportune time to enter.

Andrew Mattock: I would add that within Hong Kong, which

is where the majority of our investments are at Matthews, the

market is cheap.

MATTHEWS ASIA ANALYSIS OF MARKET EVENTS IN CHINA

©2016 Matthews International Capital Management, LLC       5

Past performance is no guarantee of future results. The views and information discussed in this report are as of January 7, are

subject to change and may not reflect the writer’s current views. The views and information discussed in this report are as of

the date of publication, are subject to change and may not reflect the writer’s current views. The views expressed represent an

assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment

advice regarding a particular investment or markets in general. The subject matter contained herein has been derived from

several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or

implied) is made as to the accuracy or completeness of any of this information. Matthews International Capital Management,

LLC does not accept any liability for losses either direct or consequential caused by the use of this information.