New Chinese milk scandal - this time with a Western culprit

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Dumex baby formula, which uses the New Zealand dairy company Fonterra as its raw material supplier, at a store in Yichang, in central China's Hubei province on August 5, 2013.

News of food contamination is once again making headlines in China. But this time, the culprit is from one of the world's most reputable food exporters.

China announced on Sunday it was halting the imports of all milk powder from New Zealand and Australia, after New Zealand-based Fonterra, the world's biggest dairy exporter, said that it had found bacteria in some products exported to the mainland that could cause botulism. a potentially fatal disease that affects the muscles and can cause respiratory problems.

China, where nearly 90 percent of milk powder imports come from New Zealand, was quick to react with a ban. The country was rocked by one of its worst food safety scandals in recent times when chemical melamine added to milk in 2008 caused thousands of people to fall ill, and also led to the deaths of infants.

Fonterra apologized for the milk powder contamination at a press briefing in Beijing on Monday and said food safety was the firm's top priority. However, the company's share price still fell sharply.

(Read More: China halts milk powder imports from New Zealand, Australia)

"Of course, nobody wants to be in this situation," Fonterra CEO Theo Spierings told CNBC at the briefing. "Sometimes, due to human errors, some things go wrong, and that is what we are trying to correct."

He added that Fonterra should be able to repair its reputation in China, and that its expansion plans there should not be impacted.

"We have to work on the issue first... and then work on what are the next steps to restoring the confidence which, I think should be possible, because we are a big operation which has been there for more than 100 years." Spierings said.

Shares of the company tumbled as much as 9 percent in Asian morning trade, but regained some ground to close down 3.5 percent. The New Zealand dollar was also hit by the food scare, falling to a one-year low of $0.7670.

China's dairy producers, on the other hand, saw their stocks soar on hopes of increased demand after the import ban. Shares of Royal Dairy and Xinjiang Western Husbandry rallied 7 percent and 10 percent respectively.

Analysts told CNBC that the incident will impact New Zealand's dairy trade, worth $9.4 billion annually, and could even hurt the country's overall economic performance.

"It [Fonterra's milk contamination] is a huge issue as far as New Zealand is concerned," said Jeremy Stretch, head of currency strategy at CIBC. "The sheer scale of the company in terms of relative importance particularly for export earnings cannot be understated."

Dairy accounts for about 25 percent of the New Zealand's exports and generates more than 7 percent of the country's gross domestic product (GDP).

(Read More: World's biggest dairy exporter issues botulism alert)

Beyond the immediate impact on demand, industry watchers also flagged longer-term concerns, especially how the food scandal could damage New Zealand's reputation as a high quality dairy producer.

Vietnam, Russia and Thailand have ordered a recall of Fonterra products, according to local media reports.

"A 50 percent fall in dairy export receipts would likely shave 0.4 percentage point off annual nominal GDP growth, with indirect effects likely making the drag even larger," said Frederick Gibson, New Zealand associate economist at Moody's Analytics.

"New Zealand's reputation is at stake and the hope that this incident isn't going to have a prolonged negative effect on that," he added.

Not everyone is concerned by the recent developments.

David Kuo, CEO at The Motley Fool Singapore, described Fonterra's situation as a "storm in a tea cup."

"I do think that companies do go through blips like this, but it depends on how quickly they manage to solve this problem," Kuo said. "They seem to be managing it well, which makes me confident about the company."

—By CNBC.com's Rajeshni Naidu-Ghelani; Follow her on Twitter @RajeshniNaidu