This directive specifies the character encoding used outside of AxKit. Internally, AxKit strictly uses UTF-8 (remember that when you write taglibs !). Filenames on the filesystem and URIs requested by browsers may use a different encoding, e.g., ISO-8859-15 for most of Europe.
This is a server-global directive, so only use it within <VirtualHost . . . > containers or at the root level. As a side effect, this option allows you to work with non-ASCII characters in URLs even outside of AxKit. Some browsers may send URLs in their local charset, although the link that was encoded in UTF-8. Others always send UTF-8 encoded URLs, regardless of link encoding. With this option set, AxKit intercepts each request and checks if the URL came encoded in UTF-8. If so, AxKit transforms it to the character encoding specified here before Apache can resolve the request, so Apache finds the file, even if it is not an AxKit file.
This does not affect the contents of documents; they have their own encoding specifier (in the <?xml . . . ?> line). For now, it affects only filenames and URL processing.