The wallpaper liner is like underlayment for a floor or roof, which you apply to the walls. It should be run vertically with tight joints but be aware, it can be torn with direct pressure over a groove. I know, walls are not made to be pushing or banging on but somehow it just seems to happen, especially if you have children around.
I think yours is a better idea than the drywall compound in the grooves; it will crack and fall out if it is distrbed at all. If you could find some wallpaper with a bold pattern that is embossed in the paper, it would help to hide more imperfections. Or you might want to use the burlaps or bamboo.