How China might have given itself a black eye

Mainland China's heavy-handed intervention in its stock market raised plenty of eyebrows in the financial community this week and damages the credibility of its broader efforts to become a more open market. ( Tweet This )

In reaction to the roughly 30 percent plunge in mainland shares from their June highs, the Chinese government stepped in with a slew of policy changes, including a virtual ban on short-selling, serious restrictions on selling by major shareholders and the loosening of margin lending regulations.

Mainland stocks, known as A-shares, rallied late in the week, with the Shanghai composite rising more than 10 percent Thursday and Friday, for its best two-day gain in six years. But the reversal comes amid suspended trade in about half of Chinese stocks that hit excessively low levels.

An investor watches an electronic board showing stock information in Beijing.
Kim Kyung-Hoon | Reuters
An investor watches an electronic board showing stock information in Beijing.

"The last week has put back financial reform for a decade," said Shaun Rein, founder and managing director of the China Market Research Group. "Rather than 'the omnipotent Chinese government,' they created panic. I'm shocked at what they did."

China's response may also have set back its efforts to attract foreign investors to its mainland markets, where individual retail investors hold most of the shares. Just last month, MSCI said it would consider adding the A-shares traded in Shenzhen and Shanghai markets to its widely followed emerging markets index if China continued to progress on issues such as transparency.

"They indicated they might consider them again, but after this, it would be hard for them to say 'yes, we're going to add their shares into the emerging market index,'" said Peter Donisanu, global research strategist at Wells Fargo Investment Institute.

MSCI did not respond to a request for comment from CNBC.

"There's a tremendous urgency within the Chinese government to move its financial system on par with the world," said Yukon Huang, senior associate of the Asia program at the Carnegie Endowment for International Peace.

The collapse of the stock market follows a rapid surge higher, with an increase of more than 100 percent in less than a year. This was partly driven by the easy access to margin lending, and encouragement from the government that the equities markets were a good place to invest.

Read MorePisani: China's stock mess made a hornet's nest

Huang said the government may have moved too quickly in its desire to join the global stage of more developed marketplaces. "The pace of reform was probably too quick. In the U.S. we're still struggling with questions (of risk) in the banking system."

China liberalized the policies on margin lending and short selling but the activities helped exacerbate the bubble that was forming in its markets, analysts said. At the same time, it tightened some rules on real estate holdings that made stocks even more attractive.

The country's efforts to build up its stock market at home coincided with its goals to lure more investors. Last year, China launched the Shanghai-Hong Kong Stock Connect which lets foreign investors with access to the Hong Kong exchange trade a limited amount of mainland A-shares for the first time.

Just a small portion of the Chinese population is part of its burgeoning middle class. A significant amount of the population is relatively poor, and there's a wide disparity between the social classes. China ranks 88th in GDP per capita, according to the World Bank.

Wells Fargo's Donisanu described the government's efforts to encourage equity investment as a form of "social harmony."

"As a ruling one-party system, the reason they've been able to maintain this one-party system, besides by brute force, is by making them happy," he said. "The stock market is one way to make the next generation or even the present generation feel happier."

Huang, however, said China's market cannot be a world player yet. "The politically motivated objectives (connecting markets, internationalizing the yuan) has encouraged the government to liberalize and do things probably faster than it should have," he said.

Read MoreWhy China's stock market will bounce back quickly

"That kind of reform process is a decade-long, generation-long process," he said. "You have the most significant market in the U.S. still having problems."

Last November, the mainland A-shares began rising in anticipation of greater foreign inflows with the symbolic opening of the stock connect. From the program's launch, the Shanghai composite jumped about 110 percent to a peak in June, amid several interest rate cuts by the People's Bank of China.

That A-share rally turned into a bear market in the weeks after MSCI's June decision to delay inclusion of the stocks in its $4 trillion benchmark emerging markets index. The highly anticipated announcement was a blow to China, for which the addition of A-shares would smooth the way for the International Monetary Fund to approve the yuan as a reserve currency.

12-month performance

In a news briefing Thursday, IMF economic counselor and director of its research department, Olivier Blanchard, did not see major concern from the recent events in China.

"I think (the government's response to the market crisis) is largely orthogonal to the discussion of the RMB within the SDR (an international reserve asset)," he said in a question-and-answer session.

Nomura's head of China equity research, Wendy Liu, was less concerned about the turmoil in Chinese markets and regulators. Speaking from Hong Kong, she called the volatility a "collective learning experience."

"I think for seasoned investors they have to set these aside and say there are good companies," she said. "I do see with this episode some of those mechanisms will need to be improved."

In the short-term, the uncertainty around the volatile Chinese stocks has weighed on U.S. investor sentiment and increased caution for some analysts.

Read MoreFour Shanghai market features that fuel volatility

"We believe that the biggest damage caused by the A-share market's roller-coaster ride since the middle of last year has been to investors' faith in the government's ability to manage asset prices (stock, RMB, debt and even property) reasonably smoothly," Merrill Lynch Singapore strategist David Hui said in a Thursday note.

"Also, the ripple effect from the market correction has yet to show up—we expect slower growth, poorer corporate earnings and a higher risk of a financial crisis," he added.