File level perform some kind of defrag, but if using file level is always recommend perform defrag before start the conversion process. Block level make copy of block by block image of drive instead of copy files.
Some references: Differences between file-level and block-level cloning - CNET
File-level cloning also has a benefit in that it can be used to defragment drives. Since file-level cloning does not monitor which blocks are used on the drive, the files it copies can be stored on any set of blocks that are available on the new drive. Therefore if a file is fragmented among several groups of blocks on one drive, when it is copied to the new one it will be written in a contiguous group of blocks, thereby defragmenting the file.
And VMware KB: Reducing disk volume size using VMware Converter fails