Telomere shortening is associated with aging and age-associated diseases. Additionally, telomere dysfunction resulting from telomerase gene mutation can lead to premature aging, such as apparent skin atrophy and hair loss. However, the molecular signaling linking telomere dysfunction to skin atrophy remains elusive. Here we show that dysfunctional telomere disrupts BMP/pSmad/P63 signaling, impairing epidermal stem cell specification and differentiation of skin and hair follicles. We find that telomere shortening mediated by Terc loss up-regulates Follistatin (Fst), inhibiting pSmad signaling and down-regulating P63 and epidermal keratins in an ESC differentiation model as well as in adult development of telomere-shortened mice. Mechanistically, short telomeres disrupt PRC2/H3K27me3-mediated repression of Fst. Our findings reveal that skin atrophy due to telomere dysfunction is caused by a previously unappreciated link with Fst and BMP signaling that could be explored in the development of therapies.