The same thing happened to me in South America. I studied Spanish in high school, but when I asked someone a question there, they started talking at 100mph and I had no idea what they were saying.
I find it's a lot easier to understand Spanish speakers who grew up stateside. They use a more limited vocabulary, and they're Spanglish accent is a lot easier to understand.
I don't see how that's a downside of Pimsleur...
I've had a similar experience to the grandparent while learning Mandarin (not through Pimsleur), where my pronunciation has far outstripped my progress in listening, grammar, and vocabulary. Hoping to remedy this through different exercises, talking with (sympathetic) native speakers, and catching up on my Chinese soaps. ;)
On (i): any method has to make some choices on what to teach first. I think good pronunciation and listening skills are much important than knowing spelling or explicit grammar rules at the beginning. While Pimsleur is not perfect, I believe it's a good method in that respect.
On (ii): it's possible that Joe got unlucky, or maybe people in that region are monolinguals and don't quite understand that language proficiency is far being binary. It's not a big deal anyway: just learn how to say "I don't understand", "sorry, I don't speak Chinese well" and "please speak slowly". At least the first 2 of those are stock Pimsleur phrases.
For what is worth, some of us foreigners in Japan experience a different phenomenon: Japanese people who can't quite believe that non-Japanese can speak their language.
Regarding your experience in Japan, I think that's a demonstration of why learning foreign languages (and traveling)is so significant: It creates new cultural ties and has the power to jolt people out of their preconceptions and prejudices (both for learners and native speakers). It opens minds on all sides.
Which meant I, like you, had the strange ability when visiting Swedish, of speaking much better Swedish than I could understand.
Another downside to Pimsleur I discovered more recently while working on Swedish. They're all about the same! The dialogues and stories got kind of boring since I'd heard them already in Cantonese.
Ideally, I'd like a resource like Pimsleur plus some kind of podcast (e.g. popupcantonese.com) so that I could build more vocabulary at least at a passive level and understand more of the speech I elicit from native speakers.