We tried working with PhysX-moving cloth in the game, but the framerate suffered tremendously. Don't forget that physics does not yet have its own separate processing unit, so it all needs to be calculated on the main CPU, taking precious cycles away for things like AI, data streaming, sound processing, etc... And moving cloth is very heavy on the calculations, especially if it needs to interact with other items in the world (e.g. walking under a flag to make it move).
I know moving cloth has been done in other games, but as far as I know only in very small areas where not much processing power is needed for anything else (like, for example, the curtain in the confession booth somewhere at the beginning of Hitman 2 -- a very small indoor region with no enemies present).
Physics is not as lucky as graphics or sound yet, in that it can't benefit from a dedicated processor (like the GPU on a graphics card). But we have something to look forward to: in DirectX 11, future games will be able to do physics processing (among other things) on the GPU as well, thanks to the gpgpu framework
But don't worry, though: we decided to use PhysX in other, more interesting and useful ways in the game