"That pencil is small."
Translation:그 연필은 작습니다.
이것 means "this thing." Here it says "that pencil." You change 이 to either 그/저 and 것 is replaced by an actual noun, "연필."
I'm still unclear on the distinction between 그 and 저. Are they always interchangeable?
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: