Climate change and human activities have exacerbated land degradation, particularly in semi-arid wetlands. This degradation is manifested through shrub encroachment, which drives shifts in plant community composition, subsequently reshaping species diversity, and altering ecosystem function via modifications to soil properties and plant functional strategies. However, the specific soil drivers, key functional traits, and their mediating pathways remain poorly understood. This study analysed soil properties and leaf traits along shrub encroachment gradients (herbaceous, herbaceous-shrub mixed, and shrub) in the upper reaches of the Yellow River's semi-arid wetlands, China. Results showed that changes in plant diversity were accompanied by a decrease in leaf area (LA) and leaf dry matter content (LDMC), as well as an increase in leaf nitrogen content (LNC) and leaf phosphorus content (LPC). These shifts indicate that the vegetation community has adopted an adaptive resource allocation strategy and is transitioning towards a state better adapted to the changing environment. Concurrently, key soil properties in the study area, such as soil water content (SWC), electrical conductivity (EC), soil organic carbon (SOC), soil nitrogen content (SNC), and other properties, have significantly decreased compared to levels prior to shrub encroachment. Random forest models revealed the key roles of soil properties (SWC and pH) and plant functional traits (such as LA and LDMC) in driving changes in plant diversity. Variance partitioning analysis emphasised the combined effect of the interaction between soil properties and leaf functional traits in driving plant diversity variation. Consequently, structural equation modelling delineated dual pathways for SWC effects: direct negative impacts and indirect modulation via the LA-LDMC trade-off, with pH acting as a secondary regulator. This study reveals key mechanisms underpinning land degradation via shrub encroachment in semi-arid wetlands, specifically linking soil properties and plant functional traits to plant diversity change and ecosystem impairment. These findings provide a critical scientific basis for developing effective strategies for the restoration of degraded lands and sustainable land management in vulnerable semi-arid regions.