> However I would like to keep the xml:space="preserve" 
> instruction because it ensures that the output is on a 
> minimum human readable format.

It's almost always a bad idea to put xml:space="preserve" in a stylesheet. 

If you want the output to be indented, use <xsl:output indent="yes"/>.

Or if you want finer control over insertion of whitespace into the output,
use xsl:text.

Regards,

Michael Kay
http://www.saxonica.com/
http://twitter.com/michaelhkay