I want a small pool beside Zainab camp, is the only way to do this is to lower the terrain until it passes the default water level? Or can I make a small dip and then fill it with water?

No it's the only way. There is only one water level in Morrowind.

There are only these http://mw.modhistory.com/download-26-2960 you could use to simulate a shallow pond or something, but it will not really behave like water (no ripples, no swimming) and also not look like the "real" water if MGE XE is used or something. There is a bump-mapped version on the Nexus, though, which may look better.

Ok thanks

I believe TR also has a few water meshes you can use.