xml:space exists because the XML WG was influenced by the very handy <PRE> element in HTML. This tells the HTML processor not to chew up any of the white space, but to leave it as-is (it normally also has the side-effect of causing the content to be rendered in a monospace font).
Which is a useful capability, and so XML got the xml:space attribute.
That is to say, the existence of this attribute has no effect whatsoever on the required behavior of XML processors or applications. It is simply a convention that authors can use to pass a message along to whoever's downstream, requesting that the white space in some element be preserved.
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