The Queenstown Lakes District Council applied for a $9.5 million government loan for the "inner links" road through the Housing Infrastructure Fund (HIF).
But the argument the road - on the cards since 2005 - would encourage developers to build more than 1000 homes on brownfield downtown sites did not convince an independent panel.
It recommended ministers reject the bid and they have.
Three other QLDC HIF bids - Kingston, Ladies Mile and Quail Rise - were approved on Tuesday.Building and Construction Minister Dr Nick Smith said the bypass bid was not as strong as the others.
"That particular bid was not as strong in terms of the number of homes being delivered to capital contribution.
"But the Government is still leaving the door open to providing other mechanisms by which we might be able to fund that infrastructure.
"We expect to make an announcement in the next few months."
Queenstown’s mayor Jim Boult said discussions with the Government would continue.
"Put it this way, just because we’ve missed out on the [HIF] money for it certainly doesn’t mean it’s off the table," Mr Boult said.
The road is a key part of the town centre masterplan, released on Monday for consultation.
The preferred route takes in Henry St, Gorge Rd and Man St, and the Queenstown Memorial Centre could be demolished.
The aim is to take traffic off Stanley and Shotover Sts, allowing for more public transport links and pedestrianisation.
The HIF bid argued it would also encourage development - some 1144 homes in Gorge Rd, Lakeview and along the route.
Yet more houses could be built on the old Wakatipu High School site in Fryer St.
The QLDC can now apply for up to $50 million in interest-free loans to build infrastructure at the other three sites, although various consent processes still apply.
A potential 3200 homes could be built on the greenfield sites as a result, helping to tackle the resort’s housing crisis.
Quail Rise resident and ex-council candidate Terri Anderson said downtown development made more sense.
"We don’t want to set up more satellite commuting communities."
Mr Boult partly agreed.
"We’re very pleased, of course, that the Government has approved three projects, but personally I’m very much in favour of brownfield sites, more intensification in central parts of town."
He said there were lots of opportunities to develop existing downtown sites.
"So it would’ve been good if we’d got that across the line, but three out of four ain’t bad."
The project was deferred in 2014 in favour of chasing a 20% reduction in car trips through the use of public transport, walking and cycling.
The HIF bid admits that has failed.
HIF funding could have brought the completion date forward 21 years to 2019 but the project is likely to be accelerated anyway through the masterplan process.
Mr Boult said the town centre masterplan and HIF bid announcements showed wheels were now in motion towards tackling Queenstown’s growing pains.
The long-awaited $21.8 million eastern access road in Frankton, Hawthorne Drive, also opened three weeks ago.
"I wasn’t elected to sit round talking and I think we’re demonstrating we are a can-do council," Mr Boult said.
