"That pencil is small."
Translation:그 연필은 작습니다.
They are different spaces. And not interchangeable, I think so.
그 = near the listener (near you), far from the speaker (far from me) / translation: that, the
저 = far from both listener and speaker / translation: that, that over there
See a better explanation on this video:
그것은 means "That thing" whereas in this sentence the noun is already present so 것 is replaced by 연필. Your sentence's meaning would be : "That thing pencil is short." That is why it can't be used.