* Israel, Palestinians must talk despite chaos, Merkel says
* Eventual peace deal could come in stages
By Crispian Balmer
TEL AVIV, Feb 1 (Reuters) - Israel should not let the chaos in Egypt halt efforts to reach a peace deal with the Palestinians, German Chancellor Angela Merkel said on Tuesday.
"The situation in Egypt should not be seen as a reason not to continue the negotiation process. If we sit and wait, we might face an even more difficult situation," she told a security conference during a two-day visit to Israel.
"We have to achieve a two-state solution as soon as possible," she said, adding however that any peace deal might have to be agreed in stages rather than as part of a single, comprehensive treaty as often advocated by international powers.
Israeli Prime Minister Benjamin Netanyahu said on Monday after talks with Merkel that he feared Egypt, where mass protests are taking place against President Hosni Mubarak, could end up with a radical Islamic regime as had happened in Iran after its 1979 revolution.
<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
For stories on Egyptian crisis, double-click on [nLDE70O2DA]
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
Some Israeli commentators have said the security environment would change dramatically if Islamists took power in Egypt and warned that Israel's strategic needs might have to be reassessed.
Merkel said it was "unacceptable" that the Middle East peace negotiations had ground to a halt and urged Israel to bow to Palestinian demands to freeze Jewish settlement building in the occupied West Bank to revive the stalled talks.
"If, at the end of the day, a settlement freeze leads to peace, then that will outweigh the pain it might produce (in Israel)," she said, speaking through a translator.
THE COST OF WAITING
U.S.-brokered efforts to bring about an end to the decades-old conflict ran aground last year when the Palestinians refused to return to the negotiating table unless Israel extended a moratorium on its settlement building.
Netanyahu has balked at the demand, saying no other Israeli leader has had to accept such a precondition for talks.
Merkel told Israel's Institute for National Security Studies that Europe's recent financial crisis proved the danger of inaction, saying Germany and France had ignored the warning signs of fiscal fraility in countries like Greece.
"The continuation of the present standstill will not be beneficial for anyone," she said.
However, Merkel hinted that Israel and the Palestinians might have to opt for interim accords, rather than an all-embracing deal previously touted by the United States and its allies.
"You don't have to settle all questions at the first stage. Perhaps borders and security could be the first stage, and it seems to me that you have already made big advances in this area," she said.
A flood of secret documents leaked last week suggested the Palestinians and Israelis came close to a peace deal in 2008, but the talks ended when the then Israeli prime minister, Ehud Olmert, lost power and Netanyahu took office. [ID:nLDE70R18J]
"Progress was being made, then there were the elections and things slowed down for some reason," Merkel said.
She added that the entire region would benefit from a deal.
"Everything would be so much easier and would go so much more smoothly if we made progress on this Middle East peace."
(Additional reporting by Andreas Rinke, editing by Mark Trevelyan)
Our Standards: The Thomson Reuters Trust Principles.
