Here's why:
* Demonstrative adjectives point out specific nouns. They are used to modify nouns and tell us which one we are talking about.
* Demonstrative pronouns stand in place of a noun. They replace a noun that has already been mentioned.
In this case, "that" modifies the noun "cloth," telling us which specific cloth we are referring to. It doesn't replace the noun, so it's acting as an adjective.