It is a common request, but the unfortunate reality is that Word is not
currently designed for this.

If you happen to have Access availale as a tool, there is a lot to be said
for importing your data into Access (which should be able to cope with your
xml file, at least if you do some transformations first) and using Access's
reporting facilities to produce output. But even that will probably only be
straightforward if you want to print the letters, not e-mail them etc.

If you have to use Word, you can consider
a. using the customer table (or whatever it is) as the data source for the
merge, and a DATABASE field to list the transactions for that customer, e.g.
if you have an alphanumeric (text) customer ID field called CustomerID, you
might have something along the lines of

Dear { MERGEFIELD CustomerName }

Your transactions:

{ DATABASE \d "file containing the transaction data"
\c "connection info."
\s "SELECT * FROM [file or table name] WHERE [Customer ID] = '{ MERGEFIELD
CustomerID }' }

You can insert a DATABASE field by enabling the Database toolbar and using
the Insert Database button, specifying a filter condition to give you a
WHERE clause, and checking the "Insert as field" option. Assuming that
works, you can then modify the WHERE clause by inserting the mergefield (the
{} have to be the special field braces you can insert using ctrl-F9).

However, that method gives you very little control over the layout of the
resulting table (you can use some table layout switches in the DATABASE
field, but that's about it) and the data in it - you don't get decimal tabs,
for example.

b. you can use VBA. I do not know whether that option is realistic for you,
but possible approaches include:
   i) "roll your own" VBA that reads the data and constructs each document
from scratch, perhaps using boilerplate text that you get from a template or
skeleton of some kind. How to read the data depends on the format of your
data - you might use ADO to get data from Access, SQL Server, Oracle etc. or
certain types of text file, or perhaps use Microsoft's msxml parser to get
XML data.
  ii) use the Word Mailmerge events - do a merge with one record in the
data source for each customer, and construct the transaction list for each
customer prior to merging each record.

As for reading the XML, I was also a bit taken aback when all the XML
support arrived but there was no real support for its use as a data
interchange format. You could consider
a.importing into Access or Excel, if you have either of those
b. trying to use the new XML options in the { INCLUDEFILE } field to create
a table in a Word document which you can then use as a data source for a
merge. I haven't really got around to trying that yet...

one letter, each with mulitple transactions (any number of) and each
transaction can have multiple instalments (any number of or none at all)(see
example below) Surely this must be a common request for mail merging.

characters, but this approach doesn't yield very professional looking
results.

.xml input - even in Word 2003

3009</REF_ID><SEQ_ID>MS000000013740</SEQ_ID><TRAN_DATE>15/09/2002</TRAN_DATE

3009</REF_ID><SEQ_ID>MS000000013740</SEQ_ID><ORIG_VALUE>1000</ORIG_VALUE><FI
VAL>1000</FIVAL></INSTALMENT><INSTALMENT><REF_ID>
3009</REF_ID><SEQ_ID>MS000000013740</SEQ_ID><ORIG_VALUE>1000</ORIG_VALUE><FI
VAL>1000</FIVAL></INSTALMENT><INSTALMENT><REF_ID>
3009</REF_ID><SEQ_ID>MS000000013740</SEQ_ID><ORIG_VALUE>700</ORIG_VALUE><FIV
AL>700</FIVAL></INSTALMENT></TRANSACTION></ACCOUNT><ACCOUNT><REF_ID>
3010</REF_ID><NAME>V &amp; P Midlands Ltd</NAME><TRANSACTION><REF_ID>
3010</REF_ID><SEQ_ID>MS000000013471</SEQ_ID><TRAN_DATE>20/08/2002</TRAN_DATE

3010</REF_ID><SEQ_ID>MS000000013472</SEQ_ID><TRAN_DATE></TRAN_DATE><DESN>V
&amp; P Midlands
Ltd</DESN><GROSS_VAL>411.25</GROSS_VAL></TRANSACTION></ACCOUNT></LETTER