Baker, Israeli to Weigh Loan Guarantees : Settlements: The dispute focuses on U.S. efforts to restrict construction of housing for Jews in occupied areas.

Secretary of State James A. Baker III will meet Israeli Ambassador Zalman Shoval on Thursday to try to settle an emotional dispute over Israel’s request for $10 billion in loan guarantees to house and resettle Jews from the former Soviet Union.

Although the battle over U.S. efforts to stop or to drastically restrict the construction of Jewish settlements in the occupied West Bank and Gaza Strip is an explosive political issue in both countries, Shoval enters the meeting with wide latitude to strike a deal, according to diplomatic sources.

“We definitely would like to reach an agreement with the Administration without having to confront each other,” an Israeli Embassy official said.

The most likely result is a compromise that would give Israel some money, although substantially less than it is asking, under conditions that would restrict--but not block completely--settlement activity.

President Bush, who has indicated that he hopes to announce his decision on the loan guarantees before the month’s end, virtually has a free hand in the matter because Israel’s supporters in Congress admit that they have no chance of forcing the Administration to be more generous than the President wants to be.

“We haven’t overridden any vetoes up to now, and I’m not sure this would be a prime subject for an override,” said Rep. Howard Berman (D-Panorama City).

The stakes are extremely high. Bush’s decision will affect elections this year both in Israel and the United States and could become the make-or-break issue in the Arab-Israeli peace process.

Four months ago, Bush forced Israel and its allies on Capitol Hill to accept a postponement of consideration of the loan request on the grounds that any action might upset the delicate negotiations that eventually produced the Middle East peace conference in Madrid last October.

But with the 120-day delay over, the situation is even more precarious than it was last fall. The Administration has ruled out another postponement, so it must decide soon what it is prepared to do.

In the months since Israel first asked for the help, Bush and Israeli Prime Minister Yitzhak Shamir have dug themselves into seemingly irreconcilable positions regarding Jewish settlements in the occupied West Bank and Gaza Strip.

Bush has called the settlements an “obstacle to peace” and has vowed that American money will not finance them, even indirectly. Shamir has insisted that his government will continue the settlements, regardless of the opinion of Israel’s closest ally.

Despite Shamir’s often harsh rhetoric as he prepares for a general election campaign, diplomatic sources said that Shoval has been given a mandate to find a compromise that would allow both sides to save face.

The Baker-Shoval meeting is set to begin a few hours after the end of a 47-nation conference to coordinate aid to the former Soviet Union. In effect, Baker will turn to the Israel loan issue at the earliest possible moment after the conference that has dominated his attention for several days.

With Shamir facing general elections some time late this spring and Bush getting ready to run for reelection in November, the loan debate is sure to be skewed by domestic politics. And, although both governments insist that they do not want to meddle in the politics of the other, the matter is made more complicated because both Bush and Shamir have made little secret of the fact that each wishes the other government was headed by somebody else.

Whatever Bush decides, it is sure to have an impact on the Israeli election. An offer of substantial aid tied to a settlement freeze could aid Shamir’s left and center opponents who argue that Israel’s relations with the United States are more important than its determination to hold on to the occupied territories.

But if Bush makes the conditions too harsh, he would play into the hands of Shamir and his nationalist allies who could make a show of rejecting an American diktat .

“There is no way we can avoid interfering in Israeli politics,” said William B. Quandt, a scholar at the Brookings Institution in Washington. “Even another postponement would have an impact.”

Some of Israel’s American supporters have endorsed a plan first suggested by Sen. Patrick J. Leahy (D-Vt.) that would reduce the loans by a dollar for every dollar spent on West Bank and Gaza settlements. This plan would have the effect of providing Israel with some funds while seeming to punish settlement activity.

It also would give the Israeli government the option of maximizing the loans by quietly scaling back settlements while publicly insisting that it retained its right to build in the occupied territories whenever it wished.

But Berman, an outspoken supporter of Israel, said that he has doubts about the Leahy proposal “because it tries to tie two issues together that I don’t think should be linked--an Israeli settlement policy which flies in the face of an American policy and our ongoing 44-year commitment to Israel as a haven for Jews persecuted around the world.”