Paulson said India was mostly on the right path to modernise its financial sector, with a flexible currency, but China, with its tightly controlled yuan exchange rate, was increasingly the focus of protectionist sentiment around the world.
"Very often around the world, if someone doesn't like globalization, the face they put on it is the face of China," the US treasury secretary told an infrastructure conference in India's burgeoning financial capital.
Paulson said China needed to allow the yuan to rise more in the near term to reflect the strong fundamentals of an economy that data last week showed expanded in the third quarter by 11.5 percent over a year earlier.
China runs a large trade surplus with the United States, prompting some US policy makers to demand that Beijing allow its currency to rise faster to curb the pace of its exports.
Currency dealers on Monday said China could well be preparing the foreign exchange market for faster yuan appreciation after the currency jumped more than 0.3 percent against the dollar for its biggest daily gain since it was revalued in 2005.
India has averaged economic growth of 8.6 percent over the past four years.
Paulson, in the midst of a trip that also includes Kolkata and New Delhi, lauded India for allowing the rupee to appreciate but warned that limiting capital flows would hurt the country's competitiveness.
Last week, India announced restrictions on anonymous foreign investment into shares, which has sent the stock market to record highs and put upward pressure on the rupee.
Restrictions on capital flows were blunt instruments that could have unintended consequences, Paulson said.
"I urge my Indian colleagues to continue, and accelerate, their efforts to liberalize the economy and develop the financial system -- to assure that the vibrancy and growth that the Indian economy now enjoys continues well into the future," Paulson told the conference.
Speaking at the conference, Finance Minister Palaniappan Chidambaram said India introduced the curbs because of concern about investment from unregistered entities, especially unregulated ones.
"So long as funds come in after registrations, they are welcome to do so," Chidambaram said.
Paulson, in a later session with Indian journalists, said the key to success for the new rules on inflows was that they be implemented in a manner that was transparent and flexible.
One way for India to reduce the pressure from inflows would be to reduce restrictions on investment outflows, he added.
Paulson also said limits on debt and equity financing and asset allocation restrictions on financial institutions were impediments to putting resources to their most productive use.
He understood Indian officials were concerned that as Mumbai gained strength as a major financial centre, increased capital flows could increase inflationary pressures, destabilize domestic financial markets or add to exchange rate volatility.
"For the most part, India is on the right path to reduce these risks. India has allowed greater flexibility in the exchange rate in recent months, and the appreciation in the rupee has helped to reduce inflationary pressures," Paulson said.
India could take a number of steps to become more competitive in the long term, such as reducing requirements that financial institutions hold large amounts of government debt, reducing the need for banks to provide credit to priority sectors, and removing various restrictions and caps on foreign investment.
Paulson said Wall Street stood ready to help India build Mumbai into a major capital market centre, particularly in the development of a domestic bond market that would provide long-term financing for much-needed infrastructure development.
He said the United States supported India's ambitious plans to attract public-private partnerships to help finance its infrastructure needs, but said this would require transparent and independent regulatory frameworks, where government entities do not act as both regulator and services providers.
"Investors, especially those who must make long-term commitments as in most infrastructure projects, want certainty in their operating environments," Paulson said.