* Business confidence index drops to year-earlier levels
* Capacity utilization most significant drag on index
TORONTO, Nov 13 (Reuters) - Business confidence in Canada fell in the third quarter, the second decline in a row, as sentiment deteriorated to levels of a year earlier, the Conference Board of Canada said in a report on Tuesday.
The organization's index of business confidence dropped 5.5 points from the second quarter to 92.3. In the first quarter of 2012, it stood at 101.8.
The survey reflects fragile business and investment sentiment globally as fears about Europe's debt crisis have flared up again, while the U.S. budget impasse threatens to push the world's largest economy back into recession.
The Conference Board said that capacity utilization weakened sharply from the second quarter and was the most significant factor weighing on the index.
Only 32 percent of business leaders surveyed reported that their businesses are operating at, or close to, full capacity. This was the lowest capacity utilization rate since the beginning of 2010, early on in the economic recovery.
"Low capacity utilization will put downward pressure on future investment and economic growth," the Conference Board said in a statement.
The results painted a dimmer picture than official data from September that showed Canadian industry boosted its capacity utilization in the second quarter, with the often-struggling manufacturing sector making as much of a contribution as non-manufacturing.
The Bank of Canada watches the data for any signs of overheating. It says the economy as a whole is operating close to capacity, with a very small output gap, helping the case for an eventual increase in interest rates.
Over a quarter of respondents listed excess productive capacity as a barrier to investment, again the highest percentage since early 2010, and comparable to 2009.
Bank of Canada Governor Mark Carney has repeatedly warned that the reluctance of businesses to invest is one of the main headwinds hitting the Canadian economy and is making an interest rate hike look less imminent now than earlier this year.
Only 14 percent of business leaders surveyed said they believe economic conditions will improve over the next six months, compared with 43 percent six months ago.
Two-thirds of respondents now expect conditions to remain the same, the highest percentage since 2007.
The respondents were more optimistic about the future of their own companies versus the overall economy. Fifty percent said they expect profits to improve over the next six months, down slightly from 53 percent last quarter.
The percentage of respondents who said they expect the financial position of their companies to improve over the next six months was down slightly at 47.3 percent from 49 percent last quarter.
The Conference Board conducted its survey between Sept. 12 and Oct. 10.