The latest reports from Asia have resurrected a popular rumor: that Microsoft is planning to launch its own Windows Phone smart phone and initially sell it in China, where smartphone use is exploding. However, with a delicate ecosystem of hardware partners to balance, and huge competition in China, it could be an uphill task for the software giant.

Ever since Microsoft announced its landmark Windows Phone agreement with Nokia, there have been mutterings that the company is thinking about producing its own smartphone. Earlier this month came the clearest sign yet, when the Wall Street Journal quoted officials at Microsoft parts suppliers in Asia as saying that testing had already begun. Add to this the recent launch of the Microsoft Surface tablet—which showcases the touch-screen capabilities of Windows 8 and RT operating systems—and CEO Steve Ballmer’s recent speculation that the Redmond, Washington–based firm would “obviously” make more hardware, and the case becomes even more compelling.

China is likely to be a key battleground for smartphone makers. IDC recently pegged it as the world’s largest smartphone market, and, unlike the U.S. market, it is still growing. Canalys stats put Q2 shipments at 27 percent of the world’s total, ahead of the U.S. at 16 percent. China and Asia have for some years also led in smartphone production—which accounts for Microsoft’s reported testing of the new phone with Asian suppliers.

A low-cost, high-spec smartphone from Microsoft could be popular in China. But the success of such a device will likely depend on how well the American giant partners with local firms to tailor a device for the domestic market.

Microsoft has already failed with a previous smartphone launch, the ill-fated Kin, and its only hardware success to date has been Xbox. Nonetheless, Ovum analyst Tony Cripps argues that it’s quite possible Microsoft is taking the same strategy with the smartphone that it took with its recently launched Surface tablet. “While there were risks involved, Microsoft created Surface, and it made sense to do so. Why not do it again?” he says. “It’s about staying relevant.”

However, IDC analyst Melissa Chau cautions that Redmond could find its options limited by the need to avoid upsetting existing hardware partners, just as Google’s options with its Android-based Motorola phones have been limited. Partners including Acer were somewhat hostile to its Surface launch, and Microsoft cannot afford to alienate the Windows Phone partner ecosystem.

Chau argues that Microsoft‘s testing of the device might be aimed not at a product release but at showing partners the direction it envisions for Windows Phone devices. It’s also possible the device could be kept in reserve as a ”Plan B” in case Nokia’s hardware offerings fail to capture the popular imagination and drive the platform forward, she says.

In any case, Microsoft’s biggest problem is Android. IDC’s preliminary Q3 stats put Android shipments for the period at a record-breaking 136 million units, 75 percent of all smartphones. Apple’s iOS came in second with 26 million units (14.9 percent), and Windows Phone shipments totalled 3.6 million units and just 2 percent of the market. It’s still early days for Microsoft, but with HTC and Samsung both more committed to Android than Windows Phone, only Nokia is left to blaze the trail. Android also has a 77 percent share of China’s smartphone market, according to Beijing-based analyst Analysys International.

Chau explains that China has the “fastest adoption of high-end specs at cheaper prices.” The most popular devices are slick quad core devices with screen sizes around the 13 cm mark. In the past six months alone, we’ve seen the launch of Huawei’s 11 cm Honor II, at 1,888 yuan ($305); the Xiaomi Phone 2 at 1,999 yuan ($310); ZTE’s U950 at 999 yuan ($160); and Meizu’s MX 4-core, which now retails at 2,399 yuan ($380). “They’re not innovating, but there’s an appetite for this type of hardware we don’t see in other countries,” she explains.

Local handset makers—both big brands and the huge number of smaller, low-margin “white box” producers—are also targeting the sub-1,000 yuan ($160) market with gusto, aware that the huge installed base of feature-phone users in countries like China and India will soon be looking to upgrade to a smartphone.

Canalys reckons that by 2015 almost half of Chinese smartphones will be handsets under $200. The Lenovo A65 recently came down from around 1,000 yuan ($160) in Q4 2011 to around 700 yuan ($112) in the first quarter of this year, for example.

What these handsets and more high-end devices have in common, in China at least, is that the user interface and services preloaded onto them are localized for the Chinese market. When it comes to Web services, the Chinese government’s rigorous approach to online censorship has meant that some sites Western users take for granted, like Facebook, Twitter, and even YouTube, are virtually pointless to have on a smartphone. Chinese users need Youku instead of YouTube, Sina Weibo instead of Twitter, RenRen instead of Facebook, and Taobao instead of eBay—and Baidu, not Google, is favored by around 80 percent of the search market, even on Android devices.

Some Chinese handset makers, Web companies, and mobile operators have gone a step further and built their own mobile operating systems, although success has been limited so far. Baidu (with its Yi platform), e-commerce giant Alibaba (Aliyun), Xiaomi (MIUI), and others hope that their operating systems will drive more users to their services and “build fences and drive stakes into the ground” in the country’s fast-growing mobile market, according to a recent IDC report.

Although big names including Motorola, Huawei, HTC, and Samsung have plants in countries such as Vietnam, India, and Malaysia, and while Foxconn recently unveiled plans for a huge factory in Indonesia, the majority of smartphone production remains in China. Most of the big Taiwanese companies, including Foxconn, Pegatron, Wistron, and Compal, have plants producing for most of the world’s biggest tech brands, including Apple, HP, Samsung, Dell, Nokia, and, of course, Microsoft.

Thanks to government subsidies, low wages, good infrastructure, and, most important, a centralized supply chain, China remains the number-one location for smartphone manufacturing, with the focus having spread from the historical centre of the tech world, in the Pearl River Delta around Shenzhen, to new hubs in Chengdu, Chongqing, Henan province, and elsewhere as more local governments offer financial incentives.

In the end, whatever Microsoft’s plans are in the smartphone space, it and every other Western tech giant needs to get used to a new reality—if you want to succeed in the 21st-century global smartphone market, you need to pivot towards Asia.