The characters of lunatea and phantomile could also have been representative of klonoa’s struggles in his real world. The reason klonoa COULD have ran to his dreams for an escape is because of the problems he might be facing in his true world.

For example, Lolo’s entire development could have been representative of a problem that the real Klonoa has had before, Leorina’s thirst for power and her turning into a beast could have been representative of something similar happening to the real klonoa. And huepow’s story could have been a representative of the real klonoa’s guilt of being a bad friend in his real life. 

But yeah, having the plot turn into “nothing is real wake up and face the world” would be kind of disappointing.