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I started from scratch, and the current state is this:

Encoding mostly works (except that I haven't changed 
TranslateCharmap and EncodeDecimal yet) and most of the 
decoding stuff works (DecodeASCII and DecodeCharmap are 
still unchanged) and the decoding callback helper isn't 
optimized for the "builtin" names yet (i.e. it still calls 
the handler).

For encoding the callback helper knows how to 
handle "strict", "replace", "ignore" 
and "xmlcharrefreplace" itself and won't call the callback. 
This should make the encoder fast enough. As callback name 
string comparison results are cached it might even be 
faster than the original.

The patch so far didn't require any changes to 
unicodeobject.h, stringobject.h or stringobject.c