> In directory foo relative to the current working directory?

well yes, or more exactly it's taken as (and in fact is) a relative URI
so resolved against the base uri in the static context.

You can do other things like

?select=*.xml;recurse=yes;on-error=ignore'

to say go down the directory tree and  ignore any non xml files (so it
doesn't fall over CVS directories:-)

David
see
http://www.saxonica.com/documentation/sourcedocs/collections.html