Confucius taught that all men were good and that none of them were superior to each other. Men's quality didn't depend on where they were born or what blood they had but what status they had in the society. Then, how good men were was based on their personalities and individual development. So, I think that the "inner circle" vs the "outside circle" is a misunderstanding and/or perhaps a misquote out of the context. The reasons why foreigners are looked down at in China is way beyond Confucius.

The xenophobia, in my view, has developed after the 1949 suggested below and it's intensified mostly in the new millennium. The Chinese values and the importance of ancestors which are parts of Confucius doctrine are emphasized to solidify the current leadership's position rather than the ancient teaching which suggests "benevolent and frugal rulers", since there have been a lot of foreign opportunists following PRC's WTO entry. What young Chinese learn nowadays has more to do with Marxism than Confusius as this teaching is also more convenient to keep the party within its powers which Confusius may not suit well for.

In a nutshell, the rude approach to mullticultural families that brands them as "mixed blood" and as different is simply not what Confucius would have agreed with. Moreover, the disrespect for foreign teachers that would've been considered for noble individuals within Confucius doctrine is regrettable too. Whether the current fear and hatred for strangers is brought further to new levels remains to be seen.

One possible answer may be that China with its strong Confucianist background differentiates between people in the "inner circle" and those outside such a (social) circle. That attitude includes strangers of Chinese origin and foreigners - Western as well as those of non-Han ethnic background (ethnic minorities in China). The last Imperial dynasty in China was the Qing or Manchu dynasty. They came into power by force and were never really accepted by the Han Chinese. The same for the foreigners from the West who made the Han Chinese feel humiliated from the time of the Opium Wars on till 1949 when the communists took over. They now look back to history and feel now confirmed in their ethnocentric approach.

There are other possible answers; it would make a post too lengthy to read to name and discuss all of them.