Europe's auto industry has weathered the worst downturn since World War II with help from government-backed scrapping incentives that fueled demand, but the expiry of such initiatives will shift the spotlight back to a lingering issue that mass-market car makers failed to confront during the slump: overcapacity.

The European car industry has about 35% more production capacity than it needs, depending on market cycles, analysts say. That means production lines aren't running flat out and can even be idle.

Incentives, which typically offer consumers discounts on new vehicles if they scrap aging gas guzzlers, have inflated demand during the recession and meant automakers haven't been forced to address capacity, something observers say was necessary.

"Scrappage schemes are significantly distorting the dynamics of the European market, in our view, helping to protect jobs and prevent insolvencies - but at what cost?," said Credit Suisse analyst Stuart Pearson.

Registrations of new cars in Europe in June climbed 2.4% year-on-year, the first growth in 14 months, largely due to scrappage offers, the European Automobile Manufacturers Association said Wednesday. Take-up has varied from country to country. In the U.K., for example, new-car registrations, an indicator of sales, in June remained in the red, but in Germany, which offers some of the most generous terms, registrations soared 40% year-on-year.

But most incentives likely will be exhausted by the end of 2009. Industry experts for months have said the incentives weren't the answer to problems in the car industry and analysts expect a slump in sales in 2010 as demand dries up.

PricewaterhouseCoopers expects assembly in Europe to total 14.8 million vehicles this year and 15 million in 2010. "We estimate excess capacity in the European Union in 2009 as being 6.8 million units and for 2010 at 7.2 million," said PwC analyst Calum MacRae.

In contrast, excess capacity in North America this year is estimated at 6.2 million vehicles but that figure is expected to fall to 3.25 million by 2011.

Several car makers in Europe, such as Volkswagen AG (VOW.XE) and BMW AG (BMW.XE), have reduced headcount in recent years, but European automakers have so far shied away from closing plants due to strict labor laws.

Some industry representatives believe car makers already are doing enough. "You can be assured that our auto manufacturers as well as suppliers are reducing capacities enormously in the current crisis," Matthias Wissmann, president of German automakers' association VDA, told reporters earlier this month. "We're getting as streamlined as possible." He didn't provide data.

Analysts remain unconvinced that efforts made so far will put a dent in the level of overcapacity.

"Weak demand and lower sales will exacerbate the general overcapacity of the auto industry, and lead to sometimes painful and forced restructurings," Fitch Ratings analyst Emmanuel Bulle said in a recent note.

Volkswagen and Fiat SpA (F.MI), with their extensive offerings of small cars, have been the biggest beneficiaries from the scrapping incentives and now face the biggest risk of a backlash. Volkswagen has enjoyed a strategic advantage due to its more diversified product portfolio and improved cost structure following a wide-ranging restructuring between 2005 and 2007.

French automakers PSA Peugeot-Citroen (PEUGY) and Renault SA (RNO.FR) also saw sales soar in some markets, fueled by incentives. But the underlying risk related to their strong exposure to the small-car segment was highlighted last month when Standard & Poor's lowered Renault's credit rating into junk territory.

PSA and Renault didn't return calls or emails seeking comment.

A broader consumer shift toward smaller cars has been a major concern for many automakers amid heavy investments in green technology as smaller cars tend to be have smaller profit margins than larger cars. Credit Suisse's Pearson fears that the scrapping incentives might lead to "a permanent price erosion for small and lower-medium cars."

That's also a threat for the European operations of Ford Motor Co. (F) and General Motors Corp. (GMGMQ), which both rely heavily on sales of compact cars and hatchbacks.

"History suggests that new-vehicle incentives are very difficult to remove once introduced," Pearson said.

GM currently is trying to hammer out a deal to sell a majority stake in its European operations while at the same time slashing capacity at home as part of its wide-ranging reorganization.

As volume automakers are heading for a sobering 2010 in Europe, the pain for luxury brands like BMW and Daimler AG's (DAI) Mercedes-Benz brand is expected to ease. They received less support from scrapping incentives because those measures mainly fostered demand for small, cheaper vehicles. The two premium brands have a much larger exposure to the U.S., where after a steep slump the market is expected to recover faster than in Europe.

-By Christoph Rauwald, Dow Jones Newswires; +49 69 29 725 512; christoph.rauwald@dowjones.com