The reason it works this way was so you could paste the string into code and use it.
For example (using what you have above)
I have some string like so:
string foo = "<root attrib=\"x\"";
The watch window will display this value exactly as it would be typed into source code.
Alternatively if you want to paste this as actual XML somewhere, then you would use the visualizer. Source code was picked as being the more common place for copying and pasting. When examining XML data, this probably doesn't make sense.
You could log a
connect bug to make this option configurable.