Avoid mapping share in XP mode to shares in the win7 host (\tsclient). Rather, map directly to the share (\servername\sharename).
I the end, the issue was caused by the XP Mode local file access bug (where it is extremely slow to read/write anything in the host file system). A network drive was mapped to the host Win7 computer (as drive Z:) and in the Windows XP mode, drive Z: was mapped to \tsclient\z which made it terribly slow.
I resolved the issue by changing the network card in the XP Mode Settings (via Virtual PC) from the virtual NAT NIC to the physical NIC so that I could map z: to \server\share (a path not available under the NAT NIC setting).
DOS program is working very well now.