It should be noted that encoding does not seem to encode anything, just specify what goes into the XML header.
We had problems with double-encoded UTF strings being saved to database when using this function, sending it of to a apache xml-rpc servlet and storing it in mysql database. It was solved by setting 'escaping' to just 'markup' and 'encoding' to 'UTF-8' (don't forget to set 'utf-8' in xmlrpc_decode too).
It seems that UTF-8 encoded strings gets escaped with their bytes as entities instead of their characters as entites.
