China has been told it has to make "significant and verifiable cuts" in industrial overcapacity, particularly in its steel industry.
The warning comes after a review by the European Commission of its anti-dumping investigations against China.
Surging imports from China have been widely blamed for the global collapse in steel prices.
The commission had originally planned to table a proposal on whether or not to grant market economy status (MES) to China but a decision on this has been delayed pending a full impact assessment.
Some member states, including the UK, back granting MES to China but others fear such a move would open the floodgates for ultra-cheap Chinese imports.
In recent months Beijing has intensified its campaign for automatic entitlement to market economy status in December, the 15th anniversary of its WTO accession.
The result of the impact assessment was discussed at an "orientation" debate among EU commissioners in Brussels on Wednesday.
The plan discussed by the commission stresses the link between China’s status with parallel moves to fortify Europe’s trade defences and demands on China to cut over capacity.
Afterwards, a commission spokesman said a formal proposal will be submitted later this year, possibly as soon as September, adding, "At the same time, and as stressed just this week by the Foreign Affairs Council, China should make significant and verifiable cuts in industrial over-capacity based on a clear timeline of commitments and an independent monitoring mechanism."
Speaking at a news conference following the meeting, EU trade commissioner Cecilia Malmström said, “The EU is the world's largest trading partner.
“However, trade must be fair. The current situation of overcapacity, notably in steel, has shown that we need effective trade defence instruments to uphold fair trade and address market distortions in the future."
A steep rise in steel shipments from China has stiffened political and industry opposition to the EU granting China MES under the terms of its accession to the World Trade Organisation, 15 years ago.
Granting the status, which means China would be treated the same as other advanced industrial nations, would make it harder for major economies to bring anti-dumping cases against Beijing.
The EU has subsequently sought Chinese pledges to trim the excess capacity that is swamping world steel markets.
The debate on Wednesday focused on whether, and if so how, the EU should change the treatment of China in anti-dumping and anti-subsidy investigations.
Commissioners discussed several options and agreed the EU must make sure that Europe has trade defence instruments “that can deal with the current realities, notably existing overcapacities.”
Further comment came from commission vice president Jyrki Katainen, the official responsible for jobs, growth, investment and competitiveness.
He said: "Fair and open trade is Europe's best growth lever. Today's discussion was not about whether or not China is a market economy. It is about how to adapt our trade defence instruments to deal with the realities of over-capacity and a changing international legal framework."
MEPs from the European Parliament's Socialist S&D group welcomed the decision against granting China MES.
Trade spokesman, Scottish MEP David Martin said, “We welcome the Commission’s statement that there will not be any automatic granting of market economy status to China and its intention to propose a new methodology to tackle dumping of Chinese imports."
"This is what the European Parliament lead by the S&D Group had requested in its resolution of 12 May. However, we will need to make sure that this new methodology will be able to protect our industry effectively.
"China is an important economic partner and we should continue to reinforce the links between our economies. However, this relationship must be built on solid foundations. We cannot be in a position where our industries are at a disadvantage because of Chinese products dumped on our shores.
"On reform of trade defence instruments, we must act now or soon there won't be any EU industry left to defend. The manufacturing communities of Europe cannot afford further delay. These are people’s jobs and livelihoods, whole towns that cannot afford to lose their main source of employment."
S&D spokesperson on trade relations with China, Alessia Mosca MEP, said, "We reiterate that the Parliament will reject any reform that will weaken European competitiveness and workers' protection against unfair practices."
"We will closely analyse the measures proposed by the Commission as and when they are made public and we will only support them if they are consistent with Commissioner Malmstrom's commitment to the adoption of a new alternate methodology."