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Intrinsic water use efficiency (WUEi) reflects the trade‐off between photosynthetic carbon gain and water loss through stomatal conductance and is key for understanding dryland plant responses to climate change. Stipa tenacissima is a perennial tussock C3 grass with an opportunistic, drought‐avoiding water use strategy that dominates arid and semiarid steppes across the western Mediterranean region. However, its ecophysiological responses to aridification and woody shrub encroachment, a major land‐use change in drylands worldwide, are not well‐understood.We investigated the variations in leaf stable isotopes (δ18O, δ13C, δ15N), nutrient concentrations (N, P, K), and culm water content and isotopic composition (δ18O, δ2H) of paired pure‐grass and shrub‐encroached S. tenacissima steppes along a 350 km aridity gradient in Spain (10 sites, 160 individuals).Culm water isotopes revealed that S. tenacissima is a shallow‐rooted grass that depends heavily on recent rainwater for water uptake, which may render it vulnerable to increasingly irregular rainfall combined with faster topsoil drying under climate warming and aridification. With increasing aridity, S. tenacissima enhanced leaf‐level WUEi through more stringent stomatal regulation of plant water flux and carbon assimilation (higher δ13C and δ18O), reaching exceptionally high δ13C values (−23‰ to −21‰) at the most arid steppes. Foliar N concentration was remarkably low across sites regardless of woody shrub encroachment, evidencing severe water and N co‐limitation of photosynthesis and productivity. Shrub encroachment decreased leaf P and K but did not affect S. tenacissima water status. Perennial grass cover decreased markedly with both declining winter rainfall and shrub encroachment suggesting population‐level rather than individual‐level responses of S. tenacissima to these changes.The fundamental physiological constraints of photosynthetic C3 metabolism combined with low foliar N content may hamper the ability of S. tenacissima and other drought‐avoider species with shallow roots to achieve further adaptive improvements in WUEi under increasing climatic stress. A drought‐avoiding water use strategy based on early stomatal closure and photosynthesis suppression during prolonged rainless periods may thus compromise the capacity of semiarid S. tenacissima steppes to maintain perennial grass cover, sustain productivity and cope with ongoing climate aridification at the drier parts of their current distribution. Read the free Plain Language Summary for this article on the Journal blog. [ABSTRACT FROM AUTHOR]